When companies can't pay their debts, they may have very limited options for their future. One of those options may be bankruptcy. While it is a last resort, bankruptcy can give companies a fresh start. Bankruptcy usually happens when a company has far more debt than it does equity. While debt in a company's capital structure may be a good way to finance its operations, it does come with risks. Read on to find out more about capital cost structures and how they're affected by bankruptcy costs.

Benefits of Debt Financing

The Modigliani-Miller theory is used in financial and economic studies to analyze the values of different companies. According to the theory, a company's value is based on its ability to generate revenue as well as the risk of its 澳洲幸运5官方开奖结果体彩网:underlying assets and i🅰s independent of how it distributes profits and how its o✱perations are financed.

According to the theory, companies that finance their operations with debt are more valuable than those that use equity financing. That's because there are tax advantages to using debt to manage their operations. These companies can deduct the interest on their debt, lower their 澳洲幸运5官方开奖结果体彩网:tax liability, and make themselves more profitable than those that rely solely on equity.

How to Achieve Capital Structures

Companies can different methods to finance their operations to achieve an optimal capital structure. The best way to do this is to have a good mix of debt and equity, which includes a combination of preferred and 澳洲幸运5官方开奖结果体彩网:common stock. This combination helps maximize a firm's value in the ma🐽rket while cutting down its cost of capital.

As noted above, companies can use debt financing to their advantage. But as they decide to take on more debt, their 澳洲幸运5官方开奖结果体彩网:weighted averaꦿge cost of ca🎐pital (WACC)—the average cost after taxes that companies have from capital sources to finance themselves—increases. Taking on more debt isn't always such a great idea, as servicing the debt may eat away at investors' 澳洲幸运5官方开奖结果体彩网:return on investment (ROI). That's because higher interest payments decrease earnings and cash flow, and the risk of default also inc꧋re🅘ases.

A business can achieve an optimal capital structure when there is a balance between the tax benefits and cost of debt financing and 澳洲幸运5官方开奖结果体彩网:equity financing. Although debt financing༺ is generally cheaper and has tax benefits through pretax interest payments, it is also riskier than equity f🐼inancing and shouldn't be used exclusively.

A company never wants to lever its capital structure beyond this optimal level so that its WACC is high, its interest payments ♏are high, and its risk of bankruptcy is high.

Bankruptcy Costs and Capital Structures

Bankruptcy costs vary depending on the structure and size of the company. They generally include filing fees, legal and accounting fees, the loss of human capital, and losses from selling distressed assets.

Bankruptcy costs arise when a company is more likely to default on its financial obligations because it increased its debt financing rather than using equity. As a company adds more debt to its capital structure, the company's WACC increases beyond the optimal level, further increasing bankruptcy costs. The higher costs of capital and higher risk may, in turn, increase the risk of 澳洲幸运5官方开奖结果体彩网:bankruptcy.

The costs of bankruptcy can lead companies to lower their leverage. Put simply, companies with a higher potential for bankruptcy opt for a lower debt-to-equity ratio to avoid financial devastation. Companies should account for the cost of bankruptcy when determining how much debt to assume, or even whether they should add to their debt levels at all. The cost of bankruptcy can be calculated by multiplying the probability of bankruptcy by its expected overall expenses.

The Bottom Line

Capital structure is the combination of debt and equity that companies to finance their growth and daily operations. While it may be hard to tell what a good debt-to-equity ratio may be, carrying a high level of debt is risky and can put a company into financial distress—so much so, that bankruptcy may be an option. High ban🅷kruptcy costs, which vary by company and industry, may lead companies to make changes to their capita🎐l structure such that they may try to lower their debt.