Question

According M&M, what are ‘bankruptcy costs’ and why does the presence of
bankruptcy costs make a company with high debt levels riskier?

Answer 1

Bankruptcy cost is the cost associated with the restructuring of the company when the company is not able to pay off its debt obligations and it files for bankruptcy protection. When a company has excess debt in its capital structure, there is certain level of probability that the company might default on its obligation and in that circumstances the company might file for bankruptcy protection. The presence of high bankruptcy cost makes the company more risky because during the restructuring phase of the company the creditors are not paid full debt, they have to either cut down the principal or let go off interest payment, so the creditors can not have claim on the assets of the company when it is in the restructuring phase. Also creditors are not paid in full during the bankruptcy and restructuring, this makes the high debt level riskier for the company.