Capital Structure Considerations

Bankruptcy is the legal status of an insolvent person or organization, that is, one who cannot repay the debts they owe to creditors. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor. Generally, a debtor declares bankruptcy to obtain relief from debt. This is accomplished either through a discharge of the debt or through a restructuring of the debt. Usually, when a debtor files a voluntary petition, his or her bankruptcy case commences.

Chapter 9 Bankruptcy Jefferson County, Alabama, underwent Chapter 9 bankruptcy in 2009.

In the United States, bankrupt firms normally file for Chapter 7 or 11.

Chapter 7 involves basic liquidation for businesses. It is also known as straight bankruptcy. Chapter 7 is the simplest and quickest form of bankruptcy available.

Chapter 11, also known as corporate bankruptcy, involves rehabilitation or reorganization. It is a form of corporate financial reorganization that typically allows companies to continue to function while they follow debt repayment plans.

When liquidation occurs, one must remember that bondholders and other lenders are paid back first before equity holders. Usually, there is little or no capital left over for common shareholders.

When gaining capital financing, firms must consider the possibility of bankruptcy. This is especially important when considering financing capital through debt. Suppose potential creditors sense that bankruptcy is likely. In that case, firms will have a harder time acquiring financing, and even if they do, it will probably come at a high interest rate that significantly increases the cost of debt.

These firms will have to rely heavily on equity, which once again can be seen as a negative signal about the firm's current state. It can put downward pressure on equity values. This places a high cost on raising capital, with the potential for low returns. Therefore, the firm should consider any possibility of bankruptcy and work to minimize it when designing capital structure.