Indirect Bankruptcy Costs

Because it is expensive to go bankrupt, a firm will spend resources to avoid doing so. When a firm is having significant problems in meeting its debt obligations, we say that it is experiencing financial distress. Some financially distressed firms ultimately file for bankruptcy, but most do not because they are able to recover or otherwise survive.

For example, in late 2000, analysts were speculating that one of the best-known technology companies in the world, Xerox, was headed for bankruptcy court. Xerox's financial position had become precarious as it struggled to recover from ill-advised attempts to expand beyond its core copier business, not to mention steadily intensifying competition and other troubles. However, by the fall of 2001, Xerox had sold off assets, cut operating costs, and was predicting a return to modest profitability by the end of the year. After having reached a low of $3.75 in December of 2000, the share price rebounded to about $10 when it began to look like bankruptcy would be avoided, at least, in the near term.

The costs of avoiding a bankruptcy filing incurred by a financially distressed firm are called indirect bankruptcy costs. We use the term financial distress costs to refer generically to the direct and indirect costs associated with going bankrupt and/or avoiding a bankruptcy filing.

The American Bankruptcy Institute provides extensive information (www.abiworld.org).

direct bankruptcy costs

The costs that are directly associated with bankruptcy, such as legal and administrative expenses.

indirect bankruptcy costs

The costs of avoiding a bankruptcy filing incurred by a financially distressed firm.

financial distress costs

The direct and indirect costs associated with going bankrupt or experiencing financial distress.

Ross et al.: Fundamentals I VI. Cost of Capital and I 17. Financial Leverage and I I © The McGraw-Hill of Corporate Finance, Sixth Long-Term Financial Capital Structure Policy Companies, 2002

Edition, Alternate Edition Policy

586 PART SIX Cost of Capital and Long-Term Financial Policy

The problems that come up in financial distress are particularly severe, and the financial distress costs are thus larger, when the stockholders and the bondholders are different groups. Until the firm is legally bankrupt, the stockholders control it. They, of course, will take actions in their own economic interests. Because the stockholders can be wiped out in a legal bankruptcy, they have a very strong incentive to avoid a bankruptcy filing.

The bondholders, on the other hand, are primarily concerned with protecting the value of the firm's assets and will try to take control away from stockholders. They have a strong incentive to seek bankruptcy to protect their interests and keep stockholders from further dissipating the assets of the firm. The net effect of all this fighting is that a long, drawn-out, and potentially quite expensive legal battle gets started.

Meanwhile, as the wheels of justice turn in their ponderous way, the assets of the firm lose value because management is busy trying to avoid bankruptcy instead of running the business. Normal operations are disrupted, and sales are lost. Valuable employees leave, potentially fruitful programs are dropped to preserve cash, and otherwise profitable investments are not taken.

These are all indirect bankruptcy costs, or costs of financial distress. Whether or not the firm ultimately goes bankrupt, the net effect is a loss of value because the firm chose to use debt in its capital structure. It is this possibility of loss that limits the amount of debt that a firm will choose to use.

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