When companies can't pay their debts, they may have very limited options for their future. One of those options may be bankruptcy—the legal term used to describe the process needed to help repay debts and other obligations. While it is always viewed as a last resort, bankruptcy can give companies a fresh start while offering creditors some degree of repayment based on the assets that are available for liquidation.

Bankruptcy usually happens when a company has far more debt than it does equity. While debt in a company's capital structure may be a good way to finance its operations, it does come with risks.

Read on to find out more about capital cost structures and how they're affected by bankruptcy costs.

Key Takeaways

  • Companies use debt and equity achieve an optimal capital structure and finance their operations.
  • Those that finance themselves with debt are seen as more valuable because they can use interest to decrease their tax liabilities.
  • But taking on too much debt can increase the level of risk to shareholders, as well as the risk of bankruptcy.
  • Bankruptcy costs, which include legal fees, can erode a company's overall capital structure.

The Modigliani-Miller Theory

The Modigliani and Miller theory is used in financial and economic studies to analyze the values of different companies. According to the theory, a company's value is based on its ability to generate revenue as well as the risk of its underlying assets. One important caveat is that the value of the firm is independent of how it distributes profits and how its operations are financed.

According to the theory, companies that use debt financing are far more valuable than those that finance themselves purely with equity. That's because there are tax advantages to using debt to manage their operations. These companies are able to deduct the interest on their debt, lower their tax liability, and make themselves more profitable than those that rely solely on equity.

Capital Structures

Companies can use a variety of different methods to finance their operations to achieve an optimal capital structure. The best way to do this is to have a good mix of debt and equity, which includes a combination of preferred and common stock. This combination helps maximize a firm's value in the market while cutting down its cost of capital.

As noted above, companies can use debt financing to their advantage. But as they decide to take on more debt, their weighted average cost of capital (WACC)—the average cost, after taxes, companies have from capital sources to finance themselves—increases. It isn't always such a great idea because the risk to shareholders also rises, as servicing the debt may eat away at the return on investment (ROI)—higher interest payments, which decreases earnings and cash flow. Due to the high debt in the capital structure, the cost to finance that debt increases and the risk of default increases as well.

Servicing debt may eat away at shareholders expected return on investment.

Bankruptcy Costs

Higher costs of capital and the elevated degree of risk may, in turn, lead to the risk of bankruptcy. As the company adds more debt to its capital structure, the company's WACC increases beyond the optimal level, further increasing bankruptcy costs. Put simply, bankruptcy costs arise when there is a greater likelihood a company will default on its financial obligations. In other words, when a company decides to increase its debt financing rather than use equity.

In order to avoid financial devastation, companies should take into account the cost of bankruptcy when determining how much debt to take on—even whether they should add to their debt levels at all. The cost of bankruptcy can be calculated by multiplying the probability of bankruptcy by its expected overall cost.

Bankruptcy costs vary depending on the structure and size of the company. They generally include legal fees, the loss of human capital, and losses from selling distressed assets. These potential expenses cause the company to try to achieve an optimal capital structure of debt and equity. The company can achieve an optimal capital structure when there is a balance between the tax benefits and cost of both debt financing and equity financing. Traditionally, debt financing is cheaper and has tax benefits through pretax interest payments, but it is also riskier than equity financing and shouldn't be used exclusively.

A company never wants to lever its capital structure beyond this optimal level so that its WACC is high, its interest payments are high and its risk of bankruptcy is high.