Introduction to Finance

Bankruptcy costs
include explicit expenses, such as legal and accounting fees 
and court costs, along with implicit costs, such as the use of management time and skills in 
preventing and escaping bankruptcy. Marketing the fi rm’s products and keeping good people 
on staff is diffi
cult when the fi rm is nearing bankruptcy.
16
An effi
cient market will evaluate 
bankruptcy costs 
explicit expenses, 
such as legal and accounting fees and 
court costs, along with implicit costs, 
such as the use of management time 
and skills in preventing and escaping 
bankruptcy
16
Potential customers shy away from a fi nancially troubled fi rm fearing it may not survive to provide warranty service 
or spare parts for their products. Customers may also fear fi nancial distress may lead management to reduce customer 
service or product maintenance, such as the decline in ridership for an airline when it declares bankruptcy. Good 
employees with marketable skills may decide to change jobs rather than risk unemployment due to business failure.

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18.8 Insights From Theory and Practice
589
the present value of the expected bankruptcy costs and reduce its estimate of the fi rm’s value 
accordingly.
The 
static trade-off hypothesis
states that fi rms will balance the advantages of debt 
(its lower cost and tax deductibility of interest) with its disadvantages (greater possibility 
of bankruptcy and the value of explicit and implicit bankruptcy costs). This is illustrated in 
Figure 18.8
. At low debt levels, using debt more is benefi cial because debt’s lower cost lowers 
the weighted average cost of capital (WACC) and increases the fi rm’s value. But further 
increases in debt beyond the optimal capital structure level reduce the fi rm’s value, as investors’ 
perceptions of the increased cost of bankruptcy outweigh the tax benefi ts of additional debt.
Bond ratings, discussed in Chapter 10, guide investors and managers in evaluating the risk 
of increasing debt to the capital structure. Studies have shown the probability of fi nancial dis-
tress and bankruptcy rises as a fi rm’s bond ratings decline. Some fi rms use their bond rating as 
a guide for their capital structure decision; for example, maintaining debt at a level consistent 
with an “A” bond rating. To preserve some fi nancing fl exibility, fi rms may keep their debt 
ratios lower than necessary to maintain their target debt rating. So, should they need to raise 
additional debt, they can do so and still be able to maintain their desired rating.
Table 18.7
shows the decline in senior debt ratings among U.S. fi rms. In 1980, 50 percent 
of fi rms with rated senior debt had a rating of A or higher. In 1999, in good economic times, 
only 18 percent of fi rms had an A rating or better; by 2006, the proportion had sunk lower 
to 11 percent. This has the opposite eff ect on low-rated issues; the percentage of junk bonds 
(rated BB or lower) has swelled from 32 percent in 1980 to 71 percent in 2006. Several factors