Bankruptcy is a situation in which a company no longer has sufficient funds (insolvency) to meet

its obligations and debts. It can no longer settle its current liabilities with its available assets.

Under these conditions, the company may be required to file a petition for bankruptcy in a

federal court under rules outlined in the U.S. Bankruptcy Code. Depending on the severity of the

insolvency, the United States Courts. (n.d.) define several forms of bankruptcy amongst which

we will consider as follows: a company may be required to file for a reorganizing procedure

(Chapter 11 Bankruptcy) which is designed to give the company a fresh start while offering the

creditors some degree of repayment. A company may also be required to file for a liquidation

procedure (Chapter 7 Bankruptcy) which results in the liquidation of the company because of the

discharge of all unsecured debts.

Capital structure is described as “the mix of debt and equity that a firm uses to finance its

operations” (Finance for Managers, 2015).

The more a firm relies on debt to finance its operations, the more it expands its leverage as it

exposes itself to higher variability for returns on equity or on debts. When modeling for its

capital structure, owners and managers must reach a consensus for a healthy balance between

debt financing and or equity financing. There are costs and benefits, including tax benefits

associated with each type of financing; however, debt financing carries more risks in case of

bankruptcy. “On the whole, companies tend to avoid the extreme amounts of debt that can have a

drastic influence on operating cash flows” (Finance for Managers, 2015).

During the bankruptcy process, debt financing can have a mitigated advantage since the interests

paid on debts contracted to finance the capital are tax-deductible and can, therefore, present a
certain advantage. An optimal capital structure can be realized when there is a balanced mix

between the tax benefits and the cost of both debt financing and equity financing. When

companies take on more debts, they also increase the cost of borrowing (debt service) the risk to

shareholders also rises in the form of higher interest payments resulting in lower earnings,

decreased cash-flow and poor return on investment.

References:

1. Finance for Managers (2015). Lardbucket Book Project. Licensed under a Creative Commons

by-nc-sa 3.0 (http://creativecommons.org/licenses/by-nc-sa/ 3.0/.).

2. United States Courts. (n.d.). Bankruptcy. Retrieved February 02, 2020, from

https://www.uscourts.gov/services-forms/bankruptcy