Bankruptcy Costs Theory: A Review

It can be argued that the indirect costs are insignificant or even nonexistent, provided customers and suppliers behave rationally. The expected term of existence may well be reduced by the decline in the profitability that results in bankruptcy. Shah and Hijazi (2004) discussed in their paper that if a firm face bankruptcy then it might begin to face financial distress.

Bankruptcy occurs when the fixed obligations to creditors cannot be met. In this case, there is a transfer of ownership and a formal reorganization of the capital structure of the firm. The cost associated with this transfer can be categorized as either direct or indirect. Direct costs include legal, accounting and trustee fees as well as the possible denial of income tax loss carryovers and carry backs. Indirect costs relate to opportunity costs resulting from disruptions in firm supplier or firm customer relationships that are associated with the transfer of ownership or control.

A number of authors like Baxter (1967), Hirshleifer (1970) have noted that bankruptcy costs may provide an economic rationale for the existence of a finite, optimal capital structure, and hence provide reconciliation between the MM theorem and observed firm behavior. Scott (1976), Kim (1976) has formally introduced bankruptcy costs in their models. These authors claim that an optimal, finite debt equity ration can exist, resulting from a tradeoff between the expected value of bankruptcy costs and the tax savings associated with the deductibility of interest payments. Essentially, the optimum is reached when the present value of the government subsidy is just offset by the present value of expected bankruptcy (Haugen and Senebet 1978).

Haugen and Senebet (1978) worked in their paper on liquidation of company and compared it with bankruptcy cost, they concluded that in the presence of rationality and in the absence of systematic errors in pricing by the capital market, the liquidation decision is best considered as being independent of the state of the firm or the nature of its capital structure. It follows that the present value of expected costs associated with terminating the operations of the firm is also unrelated to the degree to which the firm employs financial leverage. These costs should not play a significant role in the determination of an optimal capital structure and cannot be evoked to reconcile financial theory with capital structures observed to exist in the real world.

                                                                     

 Andrade Gregor and Steven N. Kaplan (1998) referred to Kaplan and stein (1993am 1993b) that they found that more than 30 percent of management buyout completed after 1985 defaulted later on. Kaplan and Stein attribute the increased default rates to poorly designed capital and incentive structures. Andrade Gregor and Steven N. Kaplan (1998) study the effects and sources of financial distress for thirty one highly leverage transactions. 

The analysis follows each highly leverage transaction to the resolution of financial distress. They observed that financial economists have found it difficult to measure the costs of financial distress. The difficulty is driven by an inability to distinguish whether poor performance by a firm in financial distress is caused by the financial distress itself or is caused by the same factors that pushed the firm into financial distress in the first place. They studied highly leveraged transactions that subsequently become financially distressed. They estimated the effects of financial distress on values. From pre transaction to distress resolution, the sample firms experience a small increase in value.

On the other hand they estimated the costs of financial distress and their determinants. The sample firms have positive operating margins at the time of distress that typically exceed the median industry operating margins. Consistent with some costs of distress, several firms are forced to curtail capital expenditures and a number of firms appear to sell assets at depressed prices. They found no evidence that the distressed firms engage in asset substitution of any kind. They estimated that net costs of financial distress are 10 to 20 percent of firm value. At 10 to 20 percent of firm value, our estimates of the net costs of financial distress suggest that such costs exist and are not trivial in magnitude.