Bankruptcy Costs: Some Evidence Jerold B. Warner"

INTRODUCfION AND SUMMARY

ASSUMPTIONS ABOUT THE magnitude of bankruptcy costs will have a considerable bearing on the issue of how much debt it is optimal for the firm to have in its capital structure. For example, in the original Modigliani-Miller model (1958), which abstracted from both corporate taxes and the possibility of bankruptcy, no debt/equity ratio could be regarded as optimal. Given perfect markets and rational investor behavior, they showed that the value of the firm would be invariant to its capital structure. Stiglitz (1969) has shown that the invariance result holds even when there is a positive probability of bankruptcy, but only as long as there are no transactions costs associated with bankruptcy.\ Relaxing the assumption that bankruptcy is costless and introducing a corporate tax in which interest payments can be deducted from net income reopens the possibility of optimal debt/equity ratios. Kraus and Litzenberger (1973) have developed l1- formal model dealing with this case, and on a more general level a central theme in textbook discussion of capital structure policy has become the presumed trade-off between tax savings and bankruptcy costs.2

This paper considers some issues surrounding the role of bankruptcy costs in models of capital structure. Evidence on the direct costs of corporate bankruptcy is presented for a number of railroad firms which were in bankruptcy proceedings under Section 77 of the Bankruptcy Act between 1933 and 1955. Elsewhere,J I have examined the risk and return characteristics of defaulted debt claims of firms in the railroad industry; the railroad firms whose bankruptcy costs are discussed here are a subsample of the firms whose bond returns were the subject of those studies. The ratio of direct bankruptcy costs to the market value of the firm appears to fall as the value of the firm increases. As measured here, the cost of bankruptcy is on average about one percent of the market value of the firm prior to...