The effects of asset liquidity on dynamic bankruptcy decisions

We develop a dynamic bankruptcy model with asset illiquidity. In the model, a distressed firm chooses between sell-out and default, as well as its timing under the assumption that sell-out is feasible only at Poisson jump times, where the arrival rate of acquirers stands for asset liquidity. With lower asset liquidity, the firm increases the sell-out region to mitigate the risk of not finding an acquirer until bankruptcy. Despite the larger sell-out region, lower asset liquidity increases the default probability and decreases the equity, debt, and firm values. In the optimal capital structure, with lower asset liquidity, the firm reduces leverage, but the cautious capital structure does not fully offset the increased default risk. The stock price reaction caused by sell-out depends on the sell-out timing. When the firm's asset value is not sufficiently high, the stock price jump size is an inverted U-shape with the economic state variable. Lower asset liquidity increases the jump size due to greater surprise. These results fit empirical observations.