CARESS Working Paper 96-05 Dynamic Liquidation, Adjustment of Capital Structure, and the Costs of Financial Distress

Many ...nancially distressed ...rms remain highly levered, invest little, and perform poorly after emerging from a debt restructuring. As a consequence, they often reenter distress shortly after the restructuring. This paper presents a theory of dynamic liquidation that is consistent with these ...ndings. Postponing the liquidation decision allows creditors to learn about the ...rm’s prospects and implement a better liquidation policy. However, there is a trade-o¤ between optimal liquidation and optimal investment because creditors learn more about the ...rm’s prospects if the ...rm forgoes some pro...table long-term projects. When creditors resolve this trade-o¤ in favor of learning, the ...rm su¤ers from the consequences of distress even after emerging from the restructuring. The theory has implications for the costs of ...nancial distress and bankruptcy law. ¤Department of Economics, University of Pennsylvania, Philadelphia, PA 19104-6297. I am greatly indebted to my advisors, Gary Gorton and George Mailath, for many very helpful discussions and comments and their encouragement since the very beginning of this project. I would like to thank Franklin Allen, Mike Burkart, Bruce Grundy, Lutz Hendricks, Stephen Morris, Matti Suominen, Masako Ueda, and participants at the EEA and the ESEM Meetings 1996 in Istanbul, and the EFA Meetings 1996 in Oslo for valuable suggestions. All errors and shortcomings are solely my responsibility.