Everything about Bankruptcy Costs Of Debt totally explained
Within the theory of
corporate finance,
Bankruptcy Costs of Debt are the increased costs of financing with
debt instead of
equity that result from a higher
probability of
bankruptcy. The fact that bankruptcy is generally a costly process in itself and not only a transfer of
ownership implies that these costs negatively affect the total
value of the firm. These costs can be thought of as a financial cost, in the sense that the cost of financing increases because the probability of bankruptcy increases. One way to understand this is to realize that when a firm goes bankrupt
investors holding its debt are likely to lose part or all of their
investment, and therefore investors require a higher
rate of return when investing in bonds of a firm that can easily go bankrupt. This implies that an increase in debt which ends up increasing a firm's bankruptcy probability causes an increase in these
Bankruptcy Costs of Debt.
In the
Trade-Off Theory of
capital structure, firms are supposedly choosing their level of debt financing by trading off these
Bankruptcy Costs of Debt' against
Tax benefits of debt. In particular, a firm that's trying to maximize the value for its shareholders will equalize the
marginal cost of debt that results from these bankruptcy costs with the
marginal benefit of debt that results from tax benefits.
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