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Three essays on asymmetric information and corporate defaults

Nan Chen, 2004
Faculty Advisor: Suresh Sundaresan
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Abstract

This dissertation consists of three essays on the effects of asymmetric information on firm's financial distress resolution choices, debt pricing and liquidation/reorganization decisions in bankruptcy.

The first essay studies the valuation of risky corporate debt, the firm's financing decisions and firm strategy during financial distress under asymmetric information. Using Chapter 11 as a costly state verification mechanism in a simple continuous-time setting, we characterize which firms will choose to file for the Chapter 11 Bankruptcy procedure and which will choose private workouts (in the form of strategic debt service) when the firm is in financial distress. We also provide a closed-form solution to the debt pricing problem under asymmetric information. In particular, we incorporate the learning effect into pricing by providing a clear picture of how the market's beliefs about the firm's quality evolve through the observation of the firm's debt servicing pattern. The pricing formula reduces to the well-known results of Merton, Black and Cox, Leland and others if private information can be costlessly revealed.

The second essay empirically examines information and several other factors that affect distressed firms' choice between Chapter 11 and workouts. We provide evidence that the ability of a distressed firm to restructure its debt out of bankruptcy depends on the degree of the firm's financial structure, the extent of creditor and other claimholders' coordination, the tangibility of the firm's assets, the magnitude of the firm's economic distress and severity of information, in particular, accounting problems.

In the third essay, we study the decision making problem of a value maximizing bankruptcy judge who is vested with the responsibility of deciding the future course of action concerning a corporate borrower who has entered into Chapter 11. The bankruptcy judge has less information than the borrower about the future prospects of the firm in distress and must draw costly inferences about the quality of management of the firm and update her beliefs based on noisy observations about the management. We characterize the optimal decision of the judge in terms of two boundaries: if the updated beliefs reach an upper threshold level of quality, the judge decides to reorganize the firm. On the other hand, if the updated beliefs reach a lower threshold level of quality, the judge decides to liquidate the firm. When the beliefs are strictly within these two endogenously determined triggers, the judge decides to collect more information. These boundaries are rationally anticipated by the lender and the borrower in making their choice about recontracting their loan obligations ex-ante. The model is then used to relate the probability of successful reorganization, and liquidation to the primitives: time, costs of financial distress, liquidation value and the value conditional on reorganization. We also explore how the decisions made by the lender (under receivership, for example) once the firm enters Chapter 11 might differ from the ones made by the bankruptcy judge.

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