Financial Distress: When Bankruptcy Risk Matters

Firm Parameters

Knight Corp vs Day Corp Example

Boom scenario (50% prob): EBIT = $100

Recession (50% prob): EBIT = $50

Discount rate: 10%

Knight debt repayment: $49 (safe)

Day debt repayment: $60 (risky)

Boom Cash Flow ($)

Recession Cash Flow ($)

Debt Repayment ($)

Discount Rate (%)

Deadweight Bankruptcy Costs (% of firm value) 0%

Firm Value (Without Distress Costs): --

Distress Cost Amount: --

Firm Value (After Distress Costs): --

Default Probability: --

Types of Distress Costs:

-- Direct: legal, accounting, admin fees (~3% of firm value)

-- Indirect: lost customers, supplier concerns, employee turnover, inefficient decisions

Valuation: Knight vs Day

Item	Knight	Day
Debt Repayment	$49	$60
Boom Outcome (50% prob)
-- Equity claim	$51	$40
-- Debt claim	$49	$60
Recession Outcome (50% prob)
-- Equity claim	$1	$0
-- Debt claim	$49	$50
Value of Equity (PV)	$23.64	$18.18
Value of Debt (PV)	$44.54	$50.00
Total Firm Value	$68.18	$68.18

Key Insight: Without distress costs, firm value is the same! Bankruptcy risk alone does not destroy value. The distribution between debt and equity changes, but total value = expected cash flows / discount rate.

Firm Value vs Debt Level (No Distress Costs)

MM prediction: flat line. Firm value independent of capital structure.

Firm Value vs Debt Level (With Distress Costs)

With bankruptcy costs: optimal capital structure. Increasing debt increases distress costs.

Static Tradeoff Theory: Tax Shields vs Distress Costs

V_Leveraged = V_Unlevered + PV(Tax Shields) -- PV(Distress Costs)

The Theory: Firms choose debt levels by trading off two competing forces:

Tax Shield Benefit (+): Debt is tax-deductible. Interest payments reduce taxes.
Distress Cost Penalty (-): Higher debt increases probability of financial distress and bankruptcy.

Optimal Level: The debt level where the marginal tax shield equals the marginal distress cost. Too little debt wastes the tax shield. Too much debt risks bankruptcy.

Why It Matters: This explains why real firms use moderate levels of debt. If tax shields were free, all firms would be 100% debt-financed (MM without taxes). But distress costs are real -- legal fees, lost customers, employee turnover -- so firms choose a balanced capital structure.