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Optimal Resolution of Financial Distress: A Dynamic Contracting Approach

This paper provides a formal analysis of the choice between liquidation and recapitalization when firms get into financial difficulties. We introduce the possibility of a costly recapitalization into a model of dynamic financial contracting under moral hazard. We find that the firm is never recapitalized nor liquidated in a period in which the high cash flow is realized. These two options are resorted to after a poor performance when the entrepreneur's stake in the future cashflows is low enough. There exists two possible procedures to cope with financial difficulties. When recapitalization cost is relatively high, the firm should be liquidated and no recapitalization is employed. By contrast, when recapitalization cost is low, in financial distress situation, the firm would be recapitalized up to the extent that liquidation risk is eliminated.