7. When a high risk decision works out badly, there can be disastrous bankruptcy cost. Give an example in practice and explain what kind of risks that company took. Explain what is banckruptcy cost and why it does matter
Bankruptcy costs of debt are the increased costs of financing with debt instead of equity that result from a higher probability of bankruptcy. With the increase in debt in a firm, the more its risk being unable to meet its financial obligations to creditors.A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore a highly levered firm has a higher risk of bankruptcy.
Bankruptcy costs vary for different types of firms, but they typically include legal fees, losses incurred from selling assets at distressed fire-sale prices, increased borrowing costs due to poor credit, and the departure of valuable human capital. Bankruptcy costs can also affect intangible assets and include indirect costs. For example, bankruptcy could tarnish a company’s reputation and brand equity, causing it to lose market share and competitive positioning. It can also cause suppliers to tighten trade credit terms and cause the loss of customers.
Some examples of bankruptcy costs: Normal operations are disputed, valuable emploee leave, investment opportunities are not taken, the firm’s reputation is damaged (among supplier, customers).