Bankruptcy Cost

Bankruptcy costs are usually divided into direct and indirect costs. Direct costs include fees for lawyers, accountants, advisers and courts. Indirect costs are often much larger, and arise when financial difficulty damages the business: customers may stop buying, suppliers may demand cash upfront, key staff may leave, and managers may be distracted or forced to pass up profitable investments.

For example, an airline facing possible bankruptcy may find that customers avoid booking flights in advance for fear the airline will stop flying, reducing revenue just when it is most needed.

Bankruptcy costs are an important part of the trade-off theory of capital structure. Debt offers tax benefits, but more debt increases the likelihood and expected cost of financial distress. These costs limit how much debt it makes sense to use.

Bankruptcy costs are higher for companies whose value depends on intangible assets, customer trust and staff, such as technology or service businesses, than for those with tangible assets that can be sold, such as property.