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Joseph R. Mason
 Drexel University and Wharton Financial  Institutions Center 
A Real Options Approach toBankruptcy Costs: Evidence fromFailed Commercial Banks Duringthe 1990s
*
Costly bankruptcies hurt creditors and maycontribute to sluggish economic growth. More-over, the substitutability of debt and equity infinance theoryis predicated upon low bankruptcycosts. Hence, the financial literature has longsought a better understanding of the costs of  bankruptcy.Although it is generally accepted that direct  bankruptcy costs, that is, legal and administrativefees, are determined primarily by the amount of time spent in liquidation, the determinants of time itself are not well understood. Literature todate has identified three main aspects of liquida-tion time (and costs): firm size, asset specificity,and industry concentration.
1
This paper unifies thetheory behind these three aspects of bankruptcy
(
 Journal of Business,
2005, vol. 78, no. 4)
 B 
2005 by The University of Chicago. All rights reserved.0021-9398/2005/7804-013$10.00
1523
* I thank the journal editor and an anonymous referee for many helpful suggestions and offer special thanks for commentsand criticisms on earlier drafts to Mitch Berlin, Scott Besley,Charles Calomiris, Arkadev Chatterjee, Stuart Gilson, EricHiggins, Ed Kane, Jim Moser, John O’Keefe, Bill Lang, StanLonghofer,PeterNigro,DariusPalia,KarinRoland,JoaoSantos,and seminar participants at the Financial Management Associa-tion, the Federal Reserve Bank of Chicago Conference on Bank Structure and Competition, the Eastern Finance Association, North Carolina State University, and Drexel University. I grate-fully acknowledge the research assistance of Kori Egland andSarah Clark. I am solely responsible for any remaining errors.Contact the author at joe.mason@drexel.edu.1. See,forinstance,Warner(1977),Weiss(1990),andAldersonand Betker (1995; 1996).
Literatureidentifiesthreemain aspects of liquidation costs: firmsize, asset specificity,and industryconcentration. This paper unifies the theory behind these aspects of  bankruptcy costs by treat-ing them as componentsof a broader option valua-tion problem faced bythe liquidating trustee.Testing the hypothesizedasset price relationshipson FDIC failed-bank liquidation data yieldsthe appropriate results.Furthermore, it appearsthat liquidation timealone can be used as aneffective second-order  proxy for asset valuegrowth where market value estimates areunavailable.
 
costs by treating them as components of a broader option valuation problem faced by the liquidating trustee.Intuitively, the paper models the trustee’s option valuation problemin the following manner. Without loss of generality, assume the trustee bearsafiduciarydutytomaximizecreditorrecoveries.Havingtakenpos-session of the firm’s assets at a loss to creditors, the trustee’s exercise becomes one ofloss minimization. At any time
t,
the trustee may chooseto (1) liquidate at current asset values and incur a known loss or (2) holduntil the next period,
t 
þ
1, at a positive opportunity cost. The trusteewill not sell in the current period if the expected asset price growth issufficiently large. Expectations of asset price growth are partially basedon asset price volatility, which is itself related to firm size, asset speci-ficity, and industry concentration. Since the option to liquidate is not typicallyinthemoney,thetrusteewillrationallyliquidatewhenmarginalgains from waiting approach zero, that is, when the value of the optionstabilizes.The next section describes the options pricing model more formally.Section II introduces the data set. Section III introduces the estimationstrategy and assumptions. Section IV presents the analysis and results.Section V concludes.
I.
The Trustee’s Problem
How does the trustee dynamically value the put option on assets inliquidation and how does this behavior affect bankruptcy costs? First,assume the trustee faces no incentive problems and one uniform port-folio is to be liquidated. Then following Dixit and Pindyck (1994), let 
V 
equal the current market value of assets to be liquidated. Assume
V 
follows a geometric Brownian motion process such that 
d
V 
¼
a
V 
d
t 
þ
s
V 
d
 z 
;
ð
1
Þ
where
a
is a drift parameter,
s
is the variance, and
d
 z 
is the increment of a Wiener process. Equation (1) implies that the current value of theassets is known, but future values are lognormally distributed with avariance that grows linearly with the time horizon.The trustee’s divestment opportunity is equivalent to a perpetual put option. Therefore, the decision to divest is equivalent to deciding whento exercise that option.
2
Denote the value of the option to divest as
2. An American option can be though of as a variant of the perpetual option that is forcedto exercise at a limit date. The perpetual option, however, has no such limit date, so theexercise needs to be derived from a fundamental limit on the option value. It may be usefulto bear in mind the results for a Black-Scholes model of the value of a option on an equityindex that pays dividends through the following discussion. The relevant results from that model appear in Appendix B.
1524 Journal of Business
 
 F 
(
V 
). The trustee chooses the optimal time to exercise such that 
F 
(
V 
)is maximized. Let 
I 
denote the amount of creditor claims, that is, theamount that creditors ‘‘paid’’ for the assets. Then, the payoff from di-vesting at any time
t 
is
V 
t 
À
 I 
;
and at any time
t 
the trustee’s problem isone of maximizing the expected present value:
 F 
ð
V 
Þ¼
maxE
ð
V 
t 
À
 I 
Þ
e
À
r
T 
 Ã
;
ð
2
Þ
where E is the expectation operator,
T 
is the (unknown) future exercisedate,
r
is the discount rate, and the maximization is subject to (1) for 
V 
. It is important to assume that the drift parameter 
a
in (1) remains less thanthe discount rate
r
. Otherwise, waiting longer would always be the domi-nant strategy and no optimum exercise time would exist. Hence, if 
a
is allowed to vary across the business cycle, investors would be expectedto divest immediately during a cyclical contraction and wait during anexpansion.
In the following two sections, I present two different solutions to thetrustee’s problem. A deterministic solution demonstrates that, even inthe absence of uncertainty, there may be value to the creditors fromdelaying liquidation. Then, a stochastic case is used to illustrate im- portant comparative statistics tested later in the paper.
 A. Deterministic Solution
Suppose
s
in equation (1) is zero. Then,
V 
ð
t 
Þ¼
V 
0
e
a
t 
, so that, givensome current 
V,
the value of the divestment opportunity, assuming thetrustee divests at some arbitrary future time
T,
is
 F 
ð
V 
Þ¼ð
V 
e
a
T 
À
 I 
Þ
e
À
r
T 
:
ð
3
Þ
Suppose
a
0. Then,
V 
(
t 
) remains constant or declines over time,implying that it is clearly optimal to divest immediately.
A more interesting result arises when 0
<
a
<
r
. Then
F 
ð
V 
Þ
>
0even if 
V 
<
I 
in the present period, because
V 
eventually exceeds
I 
. Thiseventuality arises because, although the future value of the initial in-vestment held until
T 
decays at e
À
r
T 
, the value of assets to be liquidateddecays at the slower rate of e
Àð
r
À
a
Þ
T 
.How long will the trustee, therefore, wait? Maximizing (3) with re-spect to
T 
yields the first-order condition:
T 
*
¼
max1
a
log
r
 I 
ð
r
À
a
Þ
V 
!
;
0
& '
;
ð
4
Þ
so that if 
V 
<
½
r
=
ð
r
À
a
Þ
 I 
;
T 
*
>
0. Growth in
V 
creates value to waitingand increases the value of the trustee’s irreversible divestment opportunity.
1525
 Bankruptcy Costs
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