Costs of insolvency: Types and estimation approaches

Abstract

The purpose of the article is to construct a new classification of costs of insolvency, estimations of which are needed for management to choose optimal capital structure. To handle the purpose of the study, academic articles, related to bankruptcy costs, insolvency costs and the costs of financial distress with specific attention to cost classification, estimation methods and empirical results, have been reviewed. The findings of the paper are as follows. The traditional classification of insolvency costs divides them into direct and indirect costs. Firstly, it is shown that current methodology can only estimate aggregate effect of indirect insolvency costs and cannot distinguish their effect. Secondly, the direct insolvency costs are taken by creditors, not shareholders. Furthermore, there is empirical evidence that direct insolvency costs depend not on capital structure, but on other factors (secured claims, asset specificity and liquidity). This makes such costs irrelevant to trade-off theory because it assumes that insolvency costs depend on capital structure. Thirdly, the traditional classification omits costs of restructuring which are taken not by creditors, but by shareholders and thus are relevant for them. The paper has several implications. Firstly, research on optimal capital structure should focus more on indirect costs and costs of restructuring because those costs are relevant for shareholders. Secondly, the practical implication of the paper is assigning costs estimation methodologies to different types which is relevant to practitioners because the literature is silent on how to measure the costs.