Business Cycles and the Bankruptcy Code: A Structural Approach

We develop a structural equilibrium model with business cycles and use it to examine the economic implications of voluntary filing for bankruptcy. We find that conflict of interests that arises from the voluntary filing option of Chapter 11 causes higher ex-ante losses in firm value in recessions than in booms. These costs amount to approximately 5% of the ex-ante value for a BAA-rated representative firm and are twice as large as those produced by a model that does not allow for business cycle fluctuations. We relate these economic costs to firm fundamentals and to long-run economic uncertainty. We also show that in addition to macroeconomic conditions and liquidation costs, countercyclical distress costs and conflict of interests between debtors and creditors help to simultaneously generate reasonable credit spreads, levered equity premium and leverage ratios. Our framework nests a number of important models in the literature and we provide closed-form solutions for the equity, debt and levered asset values.