Capital Structure Considerations

How do businesses benefit from using capital structure, optimal capital structure, debt and equity, and return on investment? Businesses have the opportunity to earn more return from their investments and their blend of debt and equity capital structure. This section gives examples of how these concepts are used.

Bankruptcy Considerations

Bankruptcy occurs when an entity cannot repay the debts owed to creditors and must take action to regain solvency or liquidate.


LEARNING OBJECTIVE

  • Describe how the risk of a corporate bankruptcy can influence a company's cost of capital

KEY POINTS

    • 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.
    • In the U.S. firms that go bankrupt generally file for Chapter 7 or 11. Chapter 7 involves basic liquidation for businesses. It is also known as straight bankruptcy. Chapter 11 involves rehabilitation or reorganization while allowing the firm to continue functioning.
    • When liquidation occurs one must remember that bondholders and other lenders are paid back first before equity holders. Usually, there is little to no capital left over for common shareholders.

TERMS

  • Chapter 11

    In bankruptcy involves rehabilitation or reorganization and is known as corporate bankruptcy. It is a form of corporate financial reorganization which typically allows companies to continue to function while they follow debt repayment plans.

  • Chapter 7

    In bankruptcy involves basic liquidation for businesses. Also known as straight bankruptcy, it is the simplest and quickest form of bankruptcy available.

  • bankruptcy

    Legal status of an insolvent person or an organisation, that is, one who cannot repay the debts they owe to creditors.


Bankruptcy is a legal status of an insolvent person or an 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 U.S. firms that go bankrupt 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 involves rehabilitation or reorganization and is known as corporate bankruptcy. 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 the financing for capital, firms must take the possibility of bankruptcy into consideration. This is especially important when looking into financing capital through debt. If potential creditors sense that bankruptcy could be likely 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 a downward pressure on equity values. This places a high cost on raising capital, with potential for low returns. Therefore, it is best that the firm take into consideration any possibilities of bankruptcy and work to minimize them when designing capital structure.