Bankruptcy and Bankruptcy Costs When a firm is having difficulty paying its debts, there is a possibility

Bankruptcy and Bankruptcy Costs When a firm is having difficulty paying its debts, there is a possibility

that creditors will foreclose (that is, demand payment) on loans, causing the firm to sell assets which could impair or cease operations. But if some creditors force payment, this may disadvantage other creditors. So what has developed is an orderly way of dealing with the process of the firm paying its creditors—the process is called bankruptcy.

Bankruptcy in the United States is governed by the Bankruptcy Code, created by the Bankruptcy Reform Act of 1978. A firm may be reorganized under Chapter 11 of this Code, resulting in a restructuring of its claims, or liquidated under Chapter 7. 10

Chapter 11 bankruptcy provides the troubled firm with protection from its creditors while it tries to overcome its financial difficulties. A firm that files bankruptcy under Chapter 11 continues as a going con- cern during the process of sorting out which of its creditors get paid and how much. On the other hand, a firm that files under bankruptcy Chap- ter 7, under the management of a trustee, terminates its operations, sells its assets, and distributes the proceeds to creditors and owners.

We can classify bankruptcy costs into direct and indirect costs. Direct costs include the legal, administrative, and accounting costs associated with the filing for bankruptcy and the administration of bankruptcy. These costs are estimated to be 6.2% of the value of the firm prior to

bankruptcy. 11 For example, the fees and expenses for attorneys represent- ing shareholders and creditors’ committees in the Texaco bankruptcy were approximately $21 million. 12

The indirect costs of bankruptcy are more difficult to evaluate. Oper- ating a firm while in bankruptcy is difficult, since there are often delays in making decisions, creditors may not agree on the operations of the firm, and the objectives of creditors may be at variance with the objective of efficient operation of the firm. One estimate of the indirect costs of bankruptcy, calculated by comparing actual and expected profits prior to bankruptcy, is 10.5% of the value of the firm prior to bankruptcy. 13

10 Bankruptcy Reform Act of 1978, Public Law No. 95-598.92 Stat. 2549 (1978). 11 The direct cost is taken from the study by Edward I. Altman, “A Further Empirical

Investigation of the Bankruptcy Cost Question,” Journal of Finance (September 1984), pp. 1067–1089, based on his study of industrial firms. An earlier study [Jerold B. Warner, “Bankruptcy Costs: Some Evidence,” Journal of Finance (May 1977), pp. 337–347], estimated the direct costs of bankruptcy to be approximately 5% of the prebankruptcy market value of the firm.

12 Wall Street Journal (June 2, 1988), p. 25. 13 The indirect cost estimate is taken from Altman, “A Further Empirical Investiga-

tion,” p. 1077.

Capital Structure

Another indirect cost of bankruptcy is the loss in the value of cer- tain assets. Because many intangible assets derive their value from the continuing operations of the firm, the disruption of operations during bankruptcy may change the value of the firm. The extent to which the value of a business enterprise depends on intangibles varies among industries and among firms; so the potential loss in value from financial distress varies as well. For example, a drug company may experience a greater disruption in its business activities, than say, a steel manufac- turer, since much of the value of the drug company may be derived from the research and development that leads to new products.