The Resolution of Financial Distress

Most models of financial structure embody an assumption about financial distress that causes debt to be costly to the issuing firm. This approach has been criticized on the grounds that the assumed costs could be avoided by a costless financial reorganization. In this article we show that despite the possibility of costless reorganization, it may be rational for firms to incur significant costs in the resolution of financial distress. The main assumptions that give rise to our results are the existence of asymmetric information and of judicial discretion that allows courts to impose a reorganization on the claimants of a firm.