Chapter 17, Problem 1CQ

Bankruptcy Costs What are the direct and indirect costs of bankruptcy? Briefly explain each.

Summary Introduction

To determine: What are the direct and indirect costs of bankruptcy.

Introduction:

Direct costs: These are price that are completely associated with the production of certain products or services. Examples of direct costs are direct material costs, freight costs, commissions and so on.

Indirect costs: These are the costs that are not directly associated with the production of certain products or services. Examples of indirect costs are administration costs, transportation costs, selling and distribution costs and so on.

Explanation of Solution

The following are the direct and indirect costs of bankruptcy:

Indirect costs:

Impaired capability to perform business: Companies might suffer a loss of sales because of decrease in the confidence of consumers and loss of dependable supplies because of a lack of confidence among the suppliers.

Incentive to take large risks: When handling projects of multiple levels of risks, managers who are performing in the interest stockholders’ have an incentive scheme to undertake high risk oriented projects.

Incentive to under-invest: If a firm is facing bankruptcy, stockholders will be affected if they add equity to any new project, even when the project is having positive net present value. The reason for that is the cash flows will go to the bondholders.

Milking the property: During bankruptcy, bondholders will have the first claim to firm’s assets. At the time bankruptcy, the stockholders will have stronger incentives to vote for enhanced dividends.

Direct costs:

These are potentially legal and administrative expenses. Direct costs are related to the litigation arising from bankruptcy or liquidation. Usually, these costs include expert witness costs, lawyer’s expenses and courtroom expenses.