Bankruptcy Cost Theory

The significance of bankruptcy costs and its impact to corporate financing policy has received a great deal of attention from the financial literature. The origin of the debate can be traced back to Modigliani and Miller (1958), who suggested that both the value and cost of capital of a firm are unaffected by its corporate financing policy in a world excluding taxation.

TRADE-OFF THEORY & LEVERAGE LEVEL:

It is important to identify the link between leverage levels and the trade-off theory. Trade-off theory states that a firm will have to decide on an optimal capital structure based on: 1- benefits of tax saving of debt. 2-bankruptcy costs of debt. This means that increasing the debt until it becomes overleveraged could lead to bankruptcy costs

(p.348). Altman (1984) further demonstrated that when a firm is overleveraged it causes bankruptcy costs which affect the firm’s capital structure (can be seen from figures 2 & 3. Column 6), he did that through a regression method and a security analyst's estimation, he calculated the direct and indirect bankruptcy costs from a sample of 19 firms that went bankrupt between 1970 and 1978. Altman estimated that most of the bankrupt companies had bankruptcy costs which equalled around 20% of its value 1 year before its bankruptcy (Altman 1984, p.1087). These figures clearly show how bankruptcy costs are very significant when a firm is considering its optimal capital structure. As Altman concludes in his paper by stating that “bankruptcy costs are not trivial”.

THE SIGNIFICANCE OF BANKRUPTCY COSTS:

Many Scholars such as Warner and Haugen and Senbet believe bankruptcy costs are insignificant to the capital structure but Bharbra G. and Yao Y. (2011) who estimated indirect bankruptcy costs of large corporates in the US between 1997 and 2004; along with direct bankruptcy costs reported by Altman in 1984, show how significant the total bankruptcy costs are to a firm as a percentage of its value:

Time Period Indirect costs (% of firm value) Total bankruptcy costs (% of firm

He argued this lack of importance was caused by the inconsideration of indirect costs estimation of total bankruptcy costs and thus bankruptcy costs estimated by Warner are so low, Stone believes indirect costs are substantial especially since these costs are created even if the firm doesn’t go into bankruptcy (i.e. losing credit rating when in financial distress could lead to bankruptcy). According to Titman (1983) bankruptcy costs have to be taken into account with other costs as well as the advantages of using debt financing in the optimal capital structure decision. as it can be seen from the above table Bharbra G. and Yao Y estimate indirect bankruptcy costs to be 14.9% of a firms value prior to bankruptcy. This number is too significant for it to be ignored as in Professor Warner’s