Describe in detail the costs of bankruptcy. In your answer discuss both the direct and indirect costs

Question

What will be an ideal response?

Answer 1

Answer: There are both direct and indirect costs to bankruptcy. These are described below.
DIRECT COSTS: When a firm 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.
INDIRECT COSTS: Knowing that in bankruptcy the shareholders may lose all their wealth in the firm, managers acting in the interest of shareholders try to avoid it. As the managers' attention turns from running the business to saving the business, additional costs arise. These are the indirect costs of bankruptcy and are called financial distress costs. Such costs include loss of sales, departure of valuable employees, customers' loss of confidence in the products and services of the firm, and the setting aside of projects with good long-term future payouts. The greater the amount of debt carried by a firm, the greater the chance of bankruptcy and therefore the higher the potential financial distress costs.