Within the theory of

corporate finance Corporate finance is the area of finance that deals with the sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to all ...

, 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 or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

instead of

equity Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the diff ...

that result from a higher

probability Probability is the branch of mathematics concerning numerical descriptions of how likely an event is to occur, or how likely it is that a proposition is true. The probability of an event is a number between 0 and 1, where, roughly speaking, ...

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 debto ...

. 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 different ...

implies that these costs negatively affect the total

value Value or values may refer to: Ethics and social * Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them ** Values (Western philosophy) expands the notion of value beyo ...

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 most of the time the investor purchases some species of property. Type ...

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

investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...

, 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, such as interest payments, coupons, cas ...

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 incremented, 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 In economics, utility is the satisfaction or benefit derived by consuming a product. The marginal utility of a good or service describes how much pleasure or satisfaction is gained by consumers as a result of the increase or decrease in consump ...

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 corporat ...

there is a cost associated with filling the paperwork. 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