Direct Bankruptcy Costs

When the value of a firm's assets equals the value of its debt, then the firm is economically bankrupt in the sense that the equity has no value. However, the formal turning over of the assets to the bondholders is a legal process, not an economic one. There are legal and administrative costs to bankruptcy, and it has been remarked that bankruptcies are to lawyers what blood is to sharks.

For example, when McCrory Corp., a five-and-dime variety chain, filed for bankruptcy, creditors were promised 100 cents on the dollar and a speedy emergence from bankruptcy. It didn't happen. In fact, in March of 1996, McCrory celebrated its fourth year in bankruptcy, and, through October of 1995, $39 million in fees had been paid to lawyers, bankers, and accountants haggling over the case. This figure doesn't include at least $5 million in fees paid to keep the firm operating while in bankruptcy. McCrory finally ceased to exist altogether on September 30, 1997; its unsecured creditors received zero cents on the dollar.

Because of the expenses associated with bankruptcy, bondholders won't get all that they are owed. Some fraction of the firm's assets will "disappear" in the legal process of going bankrupt. These are the legal and administrative expenses associated with the bankruptcy proceeding. We call these costs direct bankruptcy costs.

These direct bankruptcy costs are a disincentive to debt financing. If a firm goes bankrupt, then, suddenly, a piece of the firm disappears. This amounts to a bankruptcy "tax." So a firm faces a trade-off: borrowing saves a firm money on its corporate taxes, but the more a firm borrows, the more likely it is that the firm will become bankrupt and have to pay the bankruptcy tax.

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