When a company is unable to honor its financial obligations, it files for bankruptcy. A bankruptcy filing is a legal solution that helps a company to free itself from the debt obligations. The costs associated with filing the bankruptcy is referred to as Bankruptcy Cost.
For a company, the bankruptcy cost is a deadweight economic cost for going bankrupt. Bankruptcy Cost includes costs incurred both before and after filing the bankruptcy, like legal fees, documentation fees, etc.
Table of Contents
Bankruptcy cost – Direct And Indirect
The bankruptcy cost could vary for different types of firms, but they fall under two heads – direct and indirect.
Direct cost involves cash outlays, like accounting fees, legal fees, losses due to the sale of assets at distressed prices, the rise in the borrowing cost due to the poor credit rating and also exit of the valuable employees. It may also include fees paid to administrators, liquidators, lawyers, accountants, and investment bankers.
Indirect costs are those which does involve cash outflow but makes the survival of the company or a person tougher. Bankruptcy cost can impact intangible assets, like staining the goodwill of the company, loss of market share, loss of customers trust and suppliers tightening credit terms.
Further, filing for bankruptcy also makes all your information public, including your personal information and mistakes. When you file for the bankruptcy protection, you need to complete a lot of paperwork, called the bankruptcy schedules. These schedules will ask for all the information related to the debts, assets, recent financial transactions, sources of income and expenses.
Also, a person filing for bankruptcy may have to attend a meeting of the creditors. In the meeting, the bankruptcy trustee and the creditors can ask any related question. Such meetings can get intense if the creditors are unsatisfied with the answers they get.
Types of Bankruptcy Filing
In the U.S., there are three main ways or Chapters to file bankruptcy. These chapters are 7,11, and 13.
An organization or a person filing bankruptcy under chapter 7 has to liquidate their assets to pay their debts. Also, creditors need to stop their recovery efforts from the person or organization filing Chapter 7. The bankruptcy process under Chapter 7 could last from four to six months.
Chapter 11 applies only to the company (not individuals). A bankruptcy filing under the Chapter 11 means that the company would work to restructure its debts. Basically, it shows the intent of the company to pay off its debts and at the same time stay in business. The process may take two or more years.
Chapter 13 bankruptcy filing is for individuals or self-employed persons only. Under this, the person filing the bankruptcy will work to restructure their cash flow to pay the debts. The process can take about three to five years. There is also Chapter 12, but it is only available to the fishermen and farmers.
Impact on Cost of Capital
Bankruptcy cost has an impact on the cost of capital of a company. As a company takes up more debt to get tax benefits it has to service the debt as well by making a regular interest payment. Such interest payment affects the earnings and cash flows of a firm. Each company has its own optimal capital structure, i.e. a mix of debt and equity.
But, as the company takes on more debt, breaching its optimal capital structure; the cost of servicing debt gets higher as the debt will now be riskier to the lender. The rise in the debt load also increases the bankruptcy risk and also the expected cost of bankruptcy. A company must always consider the expected cost of bankruptcy when evaluating the amount of debt.
Also, a company can calculate its bankruptcy cost by multiplying the expected cost of bankruptcy with the probability of bankruptcy. Bankruptcy Cost can easily run into millions of dollars. For instance, Enron, who filed for bankruptcy on Dec. 2, 2001, is believed to have spent more than $1 billion towards bankruptcy cost, including total legal and accounting costs.
It must be noted that honesty is very important in the bankruptcy. So, one must disclose all that is needed, including property, debts, and creditors. If the court finds out any unrevealed fact, one may not only lose the bankruptcy discharge but also face an FBI investigation.Last updated on : October 8th, 2018