The introduction of bankruptcy costs (or default costs) in financial analysis fundamentally changes the way we think about the optimal debt structure.

While taxation (interest deductibility) encourages people to take on debt, bankruptcy costs act as a countervailing force that limits this debt.

Here’s how these costs influence the debt structure:

1. The increase in the cost of debt (Risk Premium)

Financial creditors (banks, bondholders) have contractual remuneration. Their main risk is that the borrower does not comply with this contract (default), which can lead to bankruptcy.

• Mechanism: To protect themselves, creditors assess the probability of default and the expected loss in the event of default. They incorporate this estimate into the interest rate charged as  a risk premium.
• As a result, the more the company takes on debt, the greater the perceived risk of bankruptcy. As a result, the interest rate on debt (ID) increases. This increase in the cost of debt reduces or even cancels out the benefit of debt financing.

2. Neutralizing the decline in the WACC (Search for the optimum)

The optimal financial structure is a trade-off between tax savings and the cost of bankruptcy risk.

• The theory: The work of Modigliani and Miller showed that the value of the company increases with the debt thanks to taxation, but they then integrated the costs of bankruptcy to determine an optimum.
• The impact on the WACC: Initially, debt lowers the Weighted Average Cost of Capital (WACC) thanks to the tax shield. However, as leverage increases, debt becomes “risky.” The cost of debt is rising (bankruptcy risk premium) and the shareholders’ demand for profitability is exploding (via Hamada’s formula). From a certain threshold, the WACC rises: the tax advantage is “eaten” by the cost of risk.

3. Limitation of debt capacity by operational risk

The costs of bankruptcy are not just financial, they are related to the company’s ability to generate stable cash flow to service the debt.

• The rule of prudence: There is an inverse correlation between operating risk and debt capacity. If the flow of operational funds is volatile (high risk), the probability of not being able to pay the debt increases.
• The principle: We must not “pile a financial risk on top of an operational risk”. If the company operates in risky markets, it must limit its debt to avoid bankruptcy.

4. Strategic Vulnerability (Indirect Costs)

Beyond the direct cost of credit, excessive debt (increasing the risk of bankruptcy) creates strategic vulnerability.

• Loss of flexibility: Finance costs are fixed costs. In the event of competitive aggression (e.g. price wars), a company that is too indebted sees its ability to respond limited because it must preserve its cash flow to pay its creditors.
• Concrete example (Lafarge): The example of Lafarge is a perfect illustration. The company, heavily indebted, saw its ability to react reduced to a price war, eventually leading to a defensive merger (and the disappearance of the listing) to avoid the worst.

In short, bankruptcy costs prevent the company from taking on infinite debt to take advantage of the tax advantage. They impose a structural limit beyond which debt destroys value by increasing the cost of capital and weakening the company in the face of competition.