Bankruptcy Costs

Bankruptcy costs can be defined as the additional expenses that arise when a firm has a higher probability of going bankrupt due to increased debt obligations. These costs can be avoided by maintaining an optimum weighted average cost of capital and a healthy mix of equity and debt financing.

Typical bankruptcy costs can be direct or indirect, including legal fees, consulting charges, losses from the sale of assets, accounting fees, etc. These costs can severely affect the company's capital structure and goodwill while imposing heavy liabilities on an already devastated management and organization.

• Bankruptcy costs refer to the expenses a firm incurs when it legally announces bankruptcy. Such a situation arises when the firm finances its operations through excessive debt over equity.
• The costs can be calculated as the probability of the company going bankrupt multiplied by the total expenses the company incurs throughout the bankruptcy.
• Companies should follow the bankruptcy costs rules laid out by the respective governments. Apart from the protocol and procedures, the Bankruptcy Code also specifies the different costs.

Bankruptcy costs of debt are incurred when the bankruptcy of a firm is announced. It is a mounting concern for firms facing serious debt issues. But let's first take a look at bankruptcy. Bankruptcy is a financial distress where the company's debt obligations increase. Every company should maintain a satisfactory debt-equity ratio. Borrowing from creditors, raising capital from equity shareholders, and reinvesting profits are the common methods by which companies usually finance their operations.

When the company finances its activities through debt, it is accountable to more creditors. Thus, if any issue were to arise, it wouldn't be able to pay off the creditors satisfactorily. This could have legal implications, and the company would eventually face a lack of creditors for future operations. When the debt situation worsens, and companies cannot pay off the creditors, they go bankrupt.

Bankruptcy is equally financial and legal distress. The company has to take the matter to court. From then on, the bankruptcy costs of debt begin mounting. The company has to file a bunch of petitions, and it has to hire lawyers, and start liquidating its assets. It hires accountants to evaluate the assets and manage the expenses. Bankruptcy alerts the company's stakeholders, who add it to their red list. If the situation worsens, they employ their exit plan. This itself can cost the company hundreds of dollars.

Bankruptcy can cost businesses a fortune in a way to add to the legal implications and financial obligations. Therefore, it is best to manage the debt and not risk it. The tax advantage firms receive from debt financing is not adequate compensation for the costs arising out of bankruptcy.

Each country has a set of bankruptcy costs rules laid out by its government. For example, in the U.S., the Bankruptcy Code establishes the different types of fees – administrative, case filing, trustee services, etc. The tax authority also facilitates the deduction of some of these expenses to provide relief to bankrupt firms.

There are many different methods, but let's look at a straightforward calculation method.

Bankruptcy cost = Probability of bankruptcy x Total bankruptcy expenses.

• The probability of bankruptcy is important, as the higher the chances of a firm defaulting on its financial obligations, the higher the cost. 
• The total bankruptcy expenses are the sum of typical bankruptcy costs such as legal fees, accounting expenses, consulting fees, losses of human labor, and losses from the sale of assets.

 Refer to the following example to understand the calculation.

Check out these examples to get a better idea:

Example #1

Suppose Xenon-Lite is a technology company. Due to increased debt over equity, experts suggested that there was a 90% chance that the firm would go bankrupt. The following is the related information:

Total debt = $3,000,000

Total equity = $1,800,000

Legal fees = $100,000

Accounting fees = $4,000

Losses from the sale of assets = $50,000

Probability of bankruptcy = 0.9

Total bankruptcy expenses = 100,000 + 4,000+ 50,000

= $154,000

Bankruptcy cost = $138,600

Example #2

The United States Supreme Court in June 2022 ruled that a 2017 amendment to Chapter 11 of the U.S. Bankruptcy Code was unconstitutional. The amendment increased the government bankruptcy costs for debtors under Chapter 11. But the court said this was not uniform as it did not cover the states of Alabama and North Carolina. 

The ruling was in favor of Circuit City Stores Inc., which filed for bankruptcy in 2008 in Virginia. It was still under Chapter 11 in 2017 when the amendment was introduced. But it had to pay $500,000 more in bankruptcy fees than it would have, had it been established in North Carolina or Alabama. 

Bankruptcy expenses are of two types – direct and indirect:

#1 – Direct Costs

Direct costs are incurred once the firm files for bankruptcy and continue until the process is completed. Some examples of the most common direct costs involved in bankruptcy are given below.

• Legal fees – Companies have to file their bankruptcy with courts, and they require the permission of the courts to take up any major changes in the organizational structure. Sometimes, the company has to work in different jurisdictions depending on the business size. This requires lawyers from different regions and therefore adds to legal expenses. Lodging and traveling expenses associated with the judicial process are also included here.
• Accounting expenses – Bankruptcy, a major financial activity within an organization, involves a lot of accounting processes. It has significant financial implications. The company will have to hire accountants and auditors for this purpose. Accounting fees form major bankruptcy expenses.
• Losses from sales proceeds – Companies often do not have enough time to find the best buyer for their assets at the best price. Since they are in a hurry, they end up selling their assets at a loss. This also forms a significant portion of bankruptcy liabilities.

#2 – Indirect Costs

Indirect costs are those a firm incurs due to possible bankruptcy. That is, the firm is at a higher chance of bankruptcy and incurs some expenses consequently. Refer to these examples:

• Premium to creditors – Since the firm has a higher chance of financial default, the creditors try to charge a premium and collect the debt while they still can. Further, the firm faces a shortage of creditors who will be ready to finance the firm's bankruptcy. Those creditors who would lend any way do so at higher interest.
• Goodwill and reputation – A bankruptcy is a public process that severely tarnishes the company's brand value and goodwill. This might result in sales losses and shareholders selling off their equity. All these factors are additional expenses to the firm.
• Loss of human capital – Finally, the effect of bankruptcy on the stakeholders, especially employees, is significant. Anticipating an extreme situation, many employees start looking for jobs in other companies.

This has been a guide to what are Bankruptcy Costs. Here, we explain direct and indirect bankruptcy costs, its formula, calculation, and examples. You can learn more about it from the following articles –

• Technical Bankruptcy
• Bankruptcy Discharge
• Insolvency vs Bankruptcy