Question

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy, what is likely to happen?

1) Managers will become more cautious and conservative in their decision-making.
2) Managers will be motivated to take calculated risks to recover from bankruptcy.
3) Managers will avoid taking any risks and focus on minimizing losses.
4) Managers will seek external assistance to avoid bankruptcy.

Answer 1

In the context of bankruptcy, managers might take significant risks in hopes of recovery. Companies file for Chapter 11 to reorganize rather than shut down, aiming to emerge stronger post-bankruptcy. Bank stability is essential for economic health, as a lack of confidence can lead to bank runs and reduced lending activity.

Step-by-step explanation:

When managers face the incentives associated with bankruptcy, one of the indirect costs is the potential for managers to take large risks. While some may expect that managers would become more cautious, in reality, it often leads to the opposite behavior. Given the limited downside once a firm is already facing bankruptcy, managers may be incentivized to gamble on high-risk, high-reward strategies in the hope of significant recovery. This action is aligned with option 2: Managers will be motivated to take calculated risks to recover from bankruptcy. However, this strategy is not without its dangers; excessive risk-taking can further imperil the company's financial position and potentially lead to its ultimate failure.

Many firms in the United States continue operating after filing for bankruptcy because they do so under Chapter 11, which allows for reorganization rather than liquidation. This provides the opportunity to renegotiate debts, downsize operations, and restructure the business without shuttering entirely. The aim is to emerge from bankruptcy as a leaner, more efficient organization better positioned for long-term success.

During financial crises, like the one experienced during the 2008-2009 Great Recession, banks under stress may drastically reduce their lending. This can impede sectors of the economy that rely heavily on borrowing, such as business investment and home construction. Thus, the financial stability of banks is crucial to supporting overall economic health.

Furthermore, the fear of a bank's failure can lead to a bank run where multiple depositors withdraw funds simultaneously, potentially causing the bank to collapse. Lastly, as companies grow and mature, they gain access to a variety of financing options from investors who do not require personal knowledge of the managers, relying instead on publicly available financial data to inform their investment decisions.