Bankruptcy Costs of debt
Encyclopedia
Within the theory of corporate finance
, bankruptcy costs of debt are the increased costs of financing with debt
instead of equity
that result from a higher probability
of bankruptcy
. The fact that bankruptcy is generally a costly process in itself and not only a transfer of ownership
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 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.
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
, bankruptcy costs of debt are the increased costs of financing with debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
instead of equity
Ownership equity
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
that result from a higher probability
Probability
Probability is ordinarily used to describe an attitude of mind towards some proposition of whose truth we arenot certain. The proposition of interest is usually of the form "Will a specific event occur?" The attitude of mind is of the form "How certain are we that the event will occur?" The...
of bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
. The fact that bankruptcy is generally a costly process in itself and not only a transfer of ownership
Ownership
Ownership is the state or fact of exclusive rights and control over property, which may be an object, land/real estate or intellectual property. Ownership involves multiple rights, collectively referred to as title, which may be separated and held by different parties. The concept of ownership has...
implies that these costs negatively affect the total value
Value (economics)
An economic value is the worth of a good or service as determined by the market.The economic value of a good or service has puzzled economists since the beginning of the discipline. First, economists tried to estimate the value of a good to an individual alone, and extend that definition to goods...
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 holding its debt are likely to lose part or all of their investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
, and therefore investors require a higher rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
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
Capital structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
, firms are supposedly choosing their level of debt financing by trading off these bankruptcy costs of debt against tax benefits of debt
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 around the world, and until recently under the U.S...
. In particular, a firm that is trying to maximize the value for its shareholders will equalize the marginal cost
Marginal cost
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good...
of debt that results from these bankruptcy costs with the marginal benefit of debt that results from tax benefits.
See also
- Corporate financeCorporate financeCorporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
- Trade-Off Theory
- Capital structureCapital structureIn finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
- Tax benefits of debtTax benefits of debtIn 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 around the world, and until recently under the U.S...
- Financial distressFinancial distressFinancial distress is a term in Corporate Finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. Sometimes financial distress can lead to bankruptcy...
- Financial risk managementFinancial risk managementFinancial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk, particularly credit risk and market risk. Other types include Foreign exchange, Shape, Volatility, Sector, Liquidity, Inflation risks, etc...