Optimal Capital Structure and Bankruptcy Choice: Dynamic Bargaining vs Liquidation

We model a firmu0027s optimal capital structure decision in a framework in which it may later choose to enter either Chapter 11 reorganization or Chapter 7 liquidation. Creditors anticipate equityholdersu0027 ex-post reorganization incentives and price them into the ex-ante credit spreads. Using a realistic dynamic bargaining model of reorganization, the implied capital structure results in both higher credit spreads and dramatically lower leverage than existing models. If reorganization is less efficient than liquidation, the added option of reorganization can actually make equityholders worse off ex-ante, even when they liquidate on the equilibrium path.