Bankruptcy Costs

One limiting factor affecting the amount of debt a firm might use comes in the form of bankruptcy costs. As the debt-equity ratio rises, so too does the probability that the firm will be unable to pay its bondholders what was promised to them. When this happens, ownership of the firm's assets is ultimately transferred from the stockholders to the bondholders.

In principle, a firm becomes bankrupt when the value of its assets equals the value of its debt. When this occurs, the value of equity is zero, and the stockholders turn over control of the firm to the bondholders. When this takes place, the bondholders hold as-

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

17. Financial Leverage and Capital Structure Policy

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CHAPTER 17 Financial Leverage and Capital Structure Policy sets whose value is exactly equal to what is owed on the debt. In a perfect world, there are no costs associated with this transfer of ownership, and the bondholders don't lose anything.

This idealized view of bankruptcy is not, of course, what happens in the real world. Ironically, it is expensive to go bankrupt. As we discuss, the costs associated with bankruptcy may eventually offset the tax-related gains from leverage.

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