The Bankruptcy Decision and Debt Contract Renegotiations

We consider the bankruptcy law and workout practices in theUnited States and model bankruptcy as a strategic decision.We analyze a firm's choice between liquidation under Chapter7, renegotiation of the debt contract in a workout, and reorganizationunder Chapter 11 of the bankruptcy code. Our premise is thata financially distressed firm chooses its action in order tominimize the loss in value caused by the well-known over- andunder-investment problems. We show that the firm initiates aworkout when it faces under-investment, and commences Chapter11 when it faces over-investment. Some of the results are: (i)in default, total firm value and equity value increase uponthe announcement of a workout and decrease upon the announcementof Chapter 11; (ii) firms with shorter maturity of debt aremore likely to reorganize in a workout; (iii) among the firmsthat renegotiate their debt contract, the proportion of firmsentering Chapter 11 is higher for firms in mature industriesthan for firms in growth industries.