Within the theory of

corporate finance Corporate finance is an area of finance that deals with the sources of funding, and the capital structure of businesses, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analy ...

, bankruptcy costs of debt are the increased costs of financing with

debt Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...

instead of equity that result from a higher

probability Probability is a branch of mathematics and statistics concerning events and numerical descriptions of how likely they are to occur. The probability of an event is a number between 0 and 1; the larger the probability, the more likely an e ...

bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...

. The fact that bankruptcy is generally a costly process in itself and not only a transfer of

ownership Ownership is the state or fact of legal possession and control over property, which may be any asset, tangible or intangible. Ownership can involve multiple rights, collectively referred to as '' title'', which may be separated and held by dif ...

implies that these costs negatively affect the total value of the firm. These costs can be thought of as a financial cost, in the sense that the cost of financing increases because the probability of bankruptcy increases. One way to understand this is to realize that when a firm goes bankrupt

investors An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital the investor usually purchases some species of property. Types of in ...

holding its debt are likely to lose part or all of their

investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

, and therefore investors require a higher

rate of return In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment over a specified time period, such as i ...

when investing in bonds of a firm that can easily go bankrupt. This implies that an increase in debt which ends up increasing a firm's bankruptcy probability causes an increase in these bankruptcy costs of debt. In the

trade-off theory of capital structure The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger ...

, firms are supposedly choosing their level of debt financing by trading off these ''bankruptcy costs of debt'' against

tax benefits of debt In the context of corporate finance, the tax benefits of debt or tax advantage of debt refers to the fact that from a tax perspective it is cheaper for firms and investors to finance with debt than with equity. Under a majority of taxation systems ...

. In particular, a firm that is trying to maximize the value for its shareholders will equalize the

marginal cost In economics, the marginal cost is the change in the total cost that arises when the quantity produced is increased, i.e. the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it ...

of debt that results from these bankruptcy costs with the

marginal benefit Marginal utility, in mainstream economics, describes the change in ''utility'' (pleasure or satisfaction resulting from the consumption) of one unit of a good or service. Marginal utility can be positive, negative, or zero. Negative marginal utilit ...

of debt that results from tax benefits. In the

personal bankruptcy Personal bankruptcy law allows, in certain jurisdictions, an individual to be declared bankrupt. Virtually every country with a modern legal system features some form of debt relief for individuals. Personal bankruptcy is distinguished from corpora ...

there is a cost associated with filling the paperwork. In the

United States The United States of America (USA), also known as the United States (U.S.) or America, is a country primarily located in North America. It is a federal republic of 50 U.S. state, states and a federal capital district, Washington, D.C. The 48 ...

, for Chapter 13 Bankruptcy there is a fee of $281 and for Chapter 7 Bankruptcy it is $306. Additionally there can be other payments required, like Lawyer's fee, Conversion fee, Credit counselling and debtor education fee. Thursday, 1 April 2021

References

Corporate finance Debt {{finance-stub

See also

References