Within the theory of corporate finance, 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 d ...

instead of equity that result from a higher probability of

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. Typ ...

holding its debt are likely to lose part or all of their investment, and therefore investors require a higher rate of return 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, firms are supposedly choosing their level of debt financing by trading off these ''bankruptcy costs of debt'' against tax benefits of debt. In particular, a firm that is trying to maximize the value for its shareholders will equalize the marginal cost of debt that results from these bankruptcy costs with the marginal benefit of debt that results from tax benefits. In the personal bankruptcy 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