Question

Explain how a firm loses value during the bankruptcy process from both a creditors and a shareholders perspective.

Answer 1

When a firm fails to pay off the debts to its creditors, the creditors file bankruptcy case in court and the court imposes bankruptcy order on the firm. In the process of bankruptcy, either the assets of the firm are sold to pay off the debts or the firm is reorganized. In both the cases of liquidating the assets or reorganizing the firm certain costs like legal, accounting, administrative and other fees are incurred. These amounts are quite high and are paid off out of the assets that the firm holds. This decreases the value of the firm from the perspective of creditors and a shareholders. Creditors won't value the company because bankruptcy filling has already questioned the credibility of the company to pay off the debts. Again, there is a possibility that the company might close if most (or all) of its assets are sold off to pay the debts. When bankruptcy is filed against a company, the share prices of the company falls substantially. When there is no clarity on the future existence of a company shareholders exit the positions in the shares of the company. When the assets are liquidated, the debt of the creditors are paid first, then preferred share holders are paid and then any remaining amount is distributed among common share holders. Thus the firm loses value from shareholders because they lose the value of their investment due to substantial fall in share price and if no amount remains after the paying to the creditors, the shareholders won't get any amount from the liquidation of assets as well.