Bankruptcy

Chapter 13 Writing Assignment

Bankruptcy is a very expensive cost for businesses. While the costs associated with bankruptcy may eventually offset the tax-related gains from leverage, a limit to the amount of debt the form may use comes in the form of what is known as bankruptcy costs. Firms can become bankrupt if its assets equal the value of its debt, thus resulting in value of equity equal to zero. At this point, stockholders would turn over control of the company to its bondholders.

As the debt-equity ratio rises for an organization, the probability that the organization will not be able to pay its bondholders increases in the same way. Legal and administrative costs exist in regards to bankruptcy and because of these expenses, bondholders usually will not get all that they are owed. These expenses are called direct bankruptcy costs and encompass any such legal and administrative expenses that are associated with the bankruptcy proceedings of an organization.

Some companies that are not in a state of zero value of equity, but have significant problems meeting debt obligations are experiencing what is known as financial distress. These companies eventually file for bankruptcy because they believe they will not be able to recover without doing so. A company in this situation may recover and can avoid a bankruptcy filing and the costs associated with such an endeavor are known as indirect bankruptcy costs. An important note about bankruptcy is that until a firm is legally bankrupt, the companies’ stockholders control it. Stockholders can be depleted in a bankruptcy, thus they are heavily inclined to avoid a bankruptcy filing. Bondholders, on the other end of the spectrum, keep the firm’s assets in protection and will seek bankruptcy if it means protecting the firm’s assets from completely depleting.