Question

What are the direct and indirect costs of bankruptcy? Briefly explain each. Additionally, some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is this proper use of the bankruptcy process?

Answer 1

Answer:

PART A

DIRECT COSTS OF BANKRUPTCY

When there is a direct outlay of cash involved, such a cost is referred to as the direct cost of bankruptcy

For example:

a) accounting fees

b) legal fees

c) losses due to sale of assets

d) administrative fee

e) court fee

Such costs are directly involved in filing of the bankruptcy.

INDIRECT COSTS OF BANKRUPTCY

The costs which usually have no direct outflow of cash as such but can make the survival difficult are referred to as the indirect costs of bankruptcy.

These may include:

a) loss of goodwill

b) loss of market share

c) loss of customer trust

d) tightening of credit terms by suppliers

PART B

According to me, it seems to be reasonable use of bankruptcy as it does not lead to a rush to the court. In other words, the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders' best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents "a race to the courthouse steps," it would seem to be reasonable use of the process.

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