Question

How does the amount of the indirect bankruptcy costs influence the financial structure of a company?

Answer 1

The capital structure of a company typically involves both debt and equity. Equity does not have any costs attached to it i.e. the company can choose to pay or not the dividends to the shareholders out of the profits earned during a year. For a company to grow at healthy pace it has to balance the amount of debt and equity being taken from external stakeholders of a company.

Indirect bankruptcy costs will mean borrowing more from external sources. The company who is trying to save itself from bankruptcy will borrow more from external sources to pay to its creditors which could be in the forms of there vendors. The external borrowing will not only skew the debt:equity ratio which means that company will be overly leveraged. Secondly it will attract heavy interest charges which will reduce the distributable profits to its common/preference share holders.

Company will have multiplier effects on the above mentioned indirect bankruptcy costs given the company is already struggling to increase its sales and will have to shell out more money in the form of interest costs. Beyond a point company will not be able to borrow more from external sources since new lenders will doubt whether they will be able to settle there previous obligations.