Costs Associated With Bankruptcy

In the previous article, we have studied about how some companies have started using bankruptcy strategically. This means that they use bankruptcy to discharge some of their debts if they are unable to meet their financial obligations. However, it needs to be understood that this discharge of debt does not happen without a cost. There is a wide variety of costs that are commonly associated with bankruptcy proceedings. Some of the costs related to bankruptcy have been mentioned in this article.

Direct Costs

  • When a company files for bankruptcy, it has to file a petition in the court. In order to do so, companies have to appoint lawyers who are specialists in the field of bankruptcy. These lawyers charge a significant sum of money as fees. Also, sometimes, lawyers have to file for bankruptcy in a different jurisdiction as compared to where their offices are. In such cases, lawyers have to travel to and fro to these locations often. The boarding, lodging and travel costs also get added to legal fees in such cases.

  • When companies file for bankruptcy, they need to get their assets valuated. In order to do so, they have to hire third-party accountants and professional valuers. These professionals also charge a significant amount of money as fees. This adds up to the cost of bankruptcy since if the company was not filing bankruptcy, it would not have any need to get its assets valued.

  • Companies that file for bankruptcy need the permission of the courts to do anything. Any kind of internal restructuring or even raising of more funds have to be approved by the court. Therefore, they have to file a lot of petitions. Sometimes, these petitions are contested by the other parties. This frequent to and fro creates a lot of legal expenses that make bankruptcy an expensive proposition.

  • In many cases, companies that file for bankruptcy have to sell their assets in order to repay their creditors. In such cases, companies are under pressure to dispose off their assets as soon as possible. Hence, they do not have the luxury of waiting until they get the best price. Therefore, they are often forced to liquidate their assets at low prices. This adds significantly to the overall cost of bankruptcy

Indirect Costs

There are many costs which are incurred by companies that file for bankruptcy. However, these costs cannot be directly attributed to bankruptcy. Some of the costs mentioned are as follows:

  • Companies that file for bankruptcy create a lot of fear in their employees. Their employees are continuously worried about the future prospects of their jobs. As a result, good employees who are capable of leaving the company and joining another one tend to do so. The company ends up losing all its best performers, which creates a huge impact if the company continues its business after filing for bankruptcy.

  • There is a significant impairment of intangible assets when a company files for bankruptcy. The brand value and the goodwill of the firm in question end up taking a hit when bankruptcy is filed. The sales of the company also get impacted since fewer people buy products because of the tarnished brand image.

  • After companies file bankruptcy, they lose the trust of their customers as well as their vendors. As a result, they witness vendors reducing the credit period and suppliers increasing the credit period. This causes a credit squeeze as the company suddenly needs more funds in the form of working capital in order to continue its operations. This becomes a significant problem since companies facing bankruptcy are already facing a shortage of funds and have to borrow at very high-interest rates.

  • Bankruptcy leads to a sudden and marked increase in the cost of capital that a firm has. Companies that are facing bankruptcy typically have more debt than they should have. Hence, there is a higher risk of default, which causes lenders to charge a premium. To make matters worse, filing bankruptcy further jeopardizes the interests of the lenders. As a result, very few lenders and willing to give funds to the company. Those willing to do so have to follow a lot of legal processes. Hence, they charge high-interest rates for the inconvenience as well as for the risk that they are undertaking.

Finding the Expected Costs of Bankruptcy

In order to decide whether or not to file for bankruptcy, companies conduct several analyses. One such analysis is wherein the company checks whether the costs of bankruptcy are less than the benefits which would accrue as a result of filing bankruptcy.

In such cases, companies often calculate their cost of bankruptcy using a probabilistic formula. This means that they multiply the expected total cost of bankruptcy with the probability of filing for bankruptcy. This means that if the cost of bankruptcy is $100 million and there is a 20% chance that the company will file for bankruptcy, the expected cost can be considered to be $20 million. The benefits that accrue as a result of filing for bankruptcy must be more than $20 million in this case in order to make the exercise worthwhile.

The bottom line is that there is a wide variety of costs that are commonly associated with filing for bankruptcy. These costs must be carefully considered before making a decision.

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