Bankruptcy costs
Bankruptcy costs are the direct (legal, administrative) and indirect (lost sales, distressed asset sales) expenses a firm bears near or in default, offsetting the tax shield in trade-off capital structure theory.
See it move
At its current debt level, a firm faces a 2% chance of financial distress costing €3,000,000, an expected cost of €60,000. Taking on extra debt raises that probability to 12%, with the same €3,000,000 cost if distress occurs — an expected cost of €360,000, €300,000 higher.
The formula
Variables
- Probability of financial distress (%)
- Cost of financial distress if it occurs (€)
Gives the value lost today from the risk of distress; used to weigh against the present value of the interest tax shield.
Check yourself
A firm is deciding whether to add more debt. At its current debt level, the probability of financial distress over the debt's life is 3%. If distress occurs, the estimated total cost (legal, administrative and lost business) is €5,000,000. Taking on the extra debt would raise the probability of distress to 20%, with the same €5,000,000 cost if it occurs. By how much does the extra debt raise the firm's expected bankruptcy cost?