Pros And Cons Of Cost Of Bankruptcy

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COSTS OF BANKRUPTCY
Besides taxes, other main additional factor that could determine capital structure is bankruptcy. The mere possibility of bankruptcy however, would not make debt less attractive. A company is an operation that attracts resources from investors, uses them and generates returns to investors according to certain agreed rules. Bankruptcy is simply a recognition that the promised payments to debt-holders are greater than the value of all the assets. Since equity-holders are residual claimants, at the point of bankruptcy, their claims are worth zero. Thus, control of the assets passes to the debt-holders, who now become the new equity-holders. The fact of bankruptcy does not change the value of the company. Just before bankruptcy,
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When a company cannot meet its debt payments on time and moves through the legal process to turn over its assets to the debt-holders, legal and administrative fees arise. These are the direct costs of bankruptcy. They reduce funds available to pay the debt-holders as these legal and administrative costs are first in line for payment at bankruptcy proceedings.
• There are 2 types of bankruptcy:
i. Involving liquidation of the company and repayment of debts in which a Trustee is appointed to oversee the liquidation of the company’s assets through an auction. The proceeds from the auction are then used to pay the debt-holders, and the company ceases to exist. ii. Which is more common, involving financial reorganization of the company. All pending collection attempts are automatically suspended, and the company’s existing management is given the opportunity to propose a reorganization plan. While developing the plan, management continues to operate the business as usual.
 The reorganization plan specifies the treatment of each creditor of the company in which:
i. Creditors may receive cash payments and/or new debt or equity securities of the

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