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COST OF FINANCIAL DISTRESS

CORPORATE FINANCE MANAGEMENT Page 1

OBJECTIVE OF THE STUDY:

The main objective of the study is to know about cost of financial distress and various types of

financial distress, the effects of financial distress, measures, indicators, Games of financial

distress and factors influencing the financial distress. We want to discuss trade off theory of

capital structure.

INTRODUCTION TO FINANCIAL DISTRESS

Financial distress is defined as a condition where obligations are not met or are met with

difficulty. A major disadvantage for a firm taking on higher levels of debt is that it increases the

risk of financial distress, and ultimately liquidation. This may have detrimental effect on both the

equity and debt holders. Financial distress is a term in Corporate Finance used to indicate a

condition when promises to creditors of a company are broken or honored with difficulty.

Sometimes financial distress can lead to bankruptcy. Financial distress is usually associated with

some costs to the company; these are known as costs of financial distress. Financial distress is

more likely to happen in bad times. The present value of distress costs therefore depends on risk

premium. We estimate this value using risk-adjusted default probabilities derived from corporate

bond spreads.

COSTS OF FINANCIAL DISTRESS

Financial distress occurs when promises to creditors are broken or honored with difficulty.

Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice.

As well as we see, financial distress is costly. Investors know that levered firms may fall into

financial distress, and they worry about it. That worry is reflected in the current market value of

the levered firms securities. Thus the value of the firm can be broken down into three parts.

Value of firm = value if all-equity-financed + PV (tax shield) - PV (costs of financial

distress)

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The cost of financial distress depends on the probability of distress and the magnitude of costsencountered if distress occurs. PV (tax shield) initially increases as the firm borrows more. at

moderate debt levels the probability of financial distress is trivial, and so PV(cost of financial

distress) is small idly with additional borrowing; the costs of distress begin to take a substantial

bite out of firm value. Also if the firm cant be sure of profiting from the corporate tax shield, the

tax advantage of additional debt is likely to dwindle and eventually disappear. The theoretical

optimum is reached when the present value of tax savings due to further borrowing is just offset

by increases in the present value of costs of distress. This is called the trade-off theory of capital

structure.

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TYPES OF COSTS OF FINANCIAL DISTRESS

INDIRECTCOSTSOFFINANCIALDISTRESS:

Indirect costs of financial distress are lost business that occurs because potential customers do

not wish to take the risk of using a company that may not be able to deliver its goods or services.

As with other indirect costs, the indirect costs of financial distress are difficult to calculate with

certainty. Indirect costs, such as loss of market share and inefficient asset sales, are believed to

be more important, but they are also much harder to quantify.

DIRECTCOSTSOFFINANCIALDISTRESS:

Any fees or penalties that result from a bankruptcy or liquidation are called direct costs of

financial distress. An obvious example is the fee one must pay to a bankruptcy attorney.

However, other fees, perhaps broker fees resulting from the liquidation of stock, may also be

attached. Direct costs of distress, such as litigation fees, are relatively small.

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A common example of a cost of financial distress is bankruptcy costs. These direct costs include

auditors' fees, legal fees, management fees and other payments. Cost of financial distress can

occur even if bankruptcy is avoided (indirect costs).

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The payout diagrams for bondholders

Financial distress in companies can lead to problems that can reduce the efficiency of

management. As maximizing firm value and maximizing shareholder value cease to be

equivalent managers who are responsible to shareholders might try to transfer value from

Creditors to shareholders.

Shareholders in case of liquidation show the reason for a conflict of interests

The result is a conflict of interest between bondholders (creditors) and shareholders. As a firm's

liquidation value slips below its debt, it is the shareholder's interest for the company to invest in

risky projects which increase the probability of the firm's value to rise over debt. Risky projects

are not in the interest of creditors, since they also increase the probability of the firms value to

decrease further, leaving them with even less. Since these projects do not necessarily have a

positive net present value, costs may arise from lost profits.

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BANKRUPTCY COSTS

Corporate bankruptcy occurs when stock holders exercise their right to default. That right is

valuable when a firm gets into trouble; limited liability allows stockholders simply to walk away

from it, leaving all its trouble to its creditors. The former creditors become the new stockholder

and the old stockholders are left with nothing.

In our legal system all stockholders in corporations automatically enjoy limited liability, but

suppose that this were not so. Suppose that are two firms with identical assets and operational,

each firm has debt outstanding and each has promised to repay Rs.1, 000 (principal and interest)

next year. But only one of the firms, Ace limited enjoys limited liability. The other firm, Ace

unlimited does not its stockholders are personally liable for its debt.

A mistake people often make in thinking about the costs of bankruptcy. Bankruptcies are thought

of as corporate funerals. The mourners (creditors and especially shareholders) look at their firms

present sad state. They think of how valuable their securities used to be and how little is left.

Moreover, they think of the lost value as a cost of bankruptcy. That is the mistake. The decline in

the value of assets is what the mourning is really about. That has no necessary connection with

financing. The bankruptcy is merely a legal mechanism for following creditors to take over when

the decline in the value of assets triggers a default. Bankruptcy is not the cause of the decline in

value. It is the result.

We said that bankruptcy is a legal mechanism allowing creditors to take over when a firm

defaults. Bankruptcy costs are the costs of using this mechanism, only ace limited can default

and go bankrupt. But regardless of what happens to asset value, the combined payoff to the

bondholders and stockholders of ace limited is always the same as the combined payoff to the

bondholders and stockholders of ace unlimited .thus overall market values of the two firms now

(this year) must be identical. Of course, ace limiteds debt is worth correspondingly less.

DIRECT VERSUS INDIRECT COSTS OF BANKRUPTCY

Managing a bankruptcy firm is not easy. Consent of the bankruptcy court is required for many

routine business decisions, such as the sale if assets or investment in new equipment. At best this

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involves time and effort, at worst the proposals are thwarted by the firms creditors who have

little interest sometimes the problem is reversed. The bankruptcy court is so anxious to maintain

the firm as a going concern that its allows the firm to engage in negative-NPV activities. We

dont know what the sum of direct and indirect costs if bankruptcy amounts to. We suspect it is a

significant number, particularly for large firms for which proceedings would be lengthy and

complex. Perhaps the best evidence is the reluctance of creditors to force bankruptcy.

FINANCIAL DISTRESS WITHOUT BANKRUPTCY:

Not every firm that gets into trouble goes bankrupt. As loans as the firm can scrape up enough

cash to pay the interest on its debt, it may be able to postpone bankruptcy for many years.

Eventually the firm may receiver, payoff its debt, and escape bankruptcy altogether. But the

mere threat of financial distress can be costly to the threatened firm. Customers and suppliers areextra cautious about business with a firm that may not be around for long. Customers worry

about resale value and the availability of service and replacement parts. Suppliers are disinclined

to put effort into servicing the distressed firms account and may demand cash on the nail for

their products. Potential employees are unwilling to sign on and existing staff keep slipping away

from their desks for job interviews.

GAMES:

RISK SHIFTING: the first game

The game illustrates the following general point: stockholders of levered firms gain when

business risk increases. Financial managers who act strictly in their shareholders interests will

favor risky projects over safe ones. They may even take risky projects with negative NPVs.

REFUSING TO CONTRIBUTE EQUITY CAPITAL: the second game

We have seen how stockholders, acting in their immediate, narrow self-interest, may take

projects that reduce the overall market value of their firm. These are errors of commission.

Conflicts of interest may also lead to errors of omission. If we hold business risk constant, any

increase in firm value is shared among bondholders and stockholders, the value of any

investment opportunity to the firms stockholders is reduced because project benefits must be

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shared with bondholders. Thus it may not be in the stockholders self-interest to contribute fresh

equity capital even if that means forgoing positive-NPV investment opportunities.

This problem theoretically affects all levered firms, but it is most serious when firms land in

financial distress. The greater the probability of default, the more bondholders have to gain from

investments than increases firm value.

And three more games, briefly:

CASH IN END RUN:

Stockholders may be reluctant to put money into a firm in financial distress, but they are happy

to make money out in the form of a cash dividend. For example. The market value of firms

stock goes down by less than the amount of the dividend paid, because the decline in firm value

is shared with creditors. This game is just refusing to contribute equity capital run in reverse.

PLAYING FOR TIME:

When the firm is in financial distress, creditors would like to salvage what they can by forcing

the firm to settle up. Naturally, stockholders want to delay this as long as they can.

BAIT AND SWITCH:

This game is not always played in financial distress, but it is a quick way to get into distress.you

start with a conservative policy, issuing a limited amount of relatively safe debt. Then you

suddenly switch and issue a lot more. That makes all your debt risky, imposing capital loss on

the Old bondholders. Their capital loss is the stockholders gain.

COSTSOFDISTRESS VARYWITHTYPEOFASSET:

Suppose your firms only asset is a large downtown hotel, mortgaged to the hilt. The recession

hits occupancy rates fall and the mortgage payments cannot be met. The lender takes over and

sells the hotel to a owner and operator. You use your firms stock certificates for wallpaper.

What is the cost of bankruptcy? In this example, probably very little. The value of the hotel is, of

course, much less than you hoped, but that is due to the lack of guests, not to the bankruptcy.

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Bankruptcy doesnt damage the hotel itself. The direct bankruptcy costs are restricted to items

such as legal and court fees, real estate commissions, and the time the lender spends things

sorting out.Do not think only about the probability that borrowing will bring trouble. Think also

of the value that may be lost if trouble comes.

THE TRADE-OFF THEORY OF CAPITAL STRUCTURE

This trade-off theory of capital structure recognizes that target debt ratios may vary from firm to

firm. Companies with safe, tangible assets and plenty of taxable income to shield ought to have

high target ratios. Unprofitable companies with risky, intangible assets ought to rely primarily on

equity financing.

If there were no costs of adjusting capital structure, then each firm should always be at its target

debt ratio. However there are costs, and therefore delays, in adjusting to the optimum. Firms

cannot immediately offset the random events that bump them away from their capital structure

targets, so we should see random differences in actual debt ratios among firms having ha same

target debt ratio.

SOME INDICATORS OF FINANCIAL DISTRESS

Financial Analysis may be used to view some of the indicators of the financial distress.

Important ratios to be considered include:

y Liquidity ratiosy Debt management ratiosy Asset utilization ratios

The ratios provide indicators on whether the firm is facing financial problems in meeting both its

current and long term debt obligations.

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FACTORS INFLUENCING THE RISK OF FINANCIAL DISTRESS COSTS

1. The sensitivity of the company's revenues to the general level of economic activity.2. The proportion of fixed to variable costs.3. The liquidity and marketability of the firm's assets.4. The cash-generative ability of the business.

EFFECTS OF FINANCIAL DISTRESS

y The risk of incurring the costs of financial distress has a negative effect on a firm's valuewhich offsets the value of tax relief of increasing debt levels.

y These costs become considerable with very high gearing. Even if a firm manages to avoidliquidation its relationships with suppliers, customers, employees and creditors may be

seriously damaged.

y Suppliers providing goods and services on credit are likely to reduce the generosity oftheir terms, or even stop supplying altogether, if they believe that there is an increased

chance of the firm not being in existence in a few months' time.y Customers may develop close relationships with their suppliers, and plan their own

production on the assumption of a continuance of that relationship. If there is any doubt

about the longevity of a firm it will not be able to secure high-quality contracts. In the

consumer markets customers often need assurance that firms are sufficiently stable to

deliver on promises.

In a financial distress situation, employees may become demotivated as they sense increased job

insecurity and few prospects for advancement. The best staff will start to move to posts in safer

companies.

Bankers and other lenders will tend to look upon a request for further finance from a financially

distressed company with a prejudiced eye taking a safety-first approach and this can continue

for many years after the crisis has passed.

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Management find that much of their time is spent "fire fighting" dealing with day-to-day

liquidity problems and focusing on short-term cash flow rather than long-term shareholder

wealth.

OPTIONS FOR RELIEVING FINANCIAL DISTRESS:

Debt restructuring is a process that allows a private or public company or a sovereign entity

facing cash flow problems and financial distress, to reduce and renegotiate its delinquent debts in

order to improve or restore liquidity and rehabilitate so that it can continue its operations.

If promises to creditors cannot be kept, bankruptcy is an option for both companies and

individuals. In the United Kingdom, the Individual Voluntary Arrangement is a formal

alternative to bankruptcy for individuals.

Restructuring is the corporate management term for the act of reorganizing the legal,

ownership, operational, or other structures of a company for the purpose of making it more

profitable, or better organized for its present needs. Alternate reasons for restructuring include a

change of ownership or ownership structure, demerger, or a response to a crisis or major changein the business such as bankruptcy, repositioning, or buyout. Restructuring may also be described

as corporate restructuring, debt restructuring and financial restructuring.

CONCLUSION:

Here we explained about cost of financial distress. Financial distress is a condition where

obligations are not met or are met with difficulty. Financial distress is a term in Corporate

Finance used to indicate a condition when promises to creditors of a company are broken orhonored with difficulty. Sometimes financial distress can lead to bankruptcy. We discussed about

the types of costs of financial distress and explained with examples. We discussed about

bankruptcy in detail. We also covered the effects and measures of financial distress. We use

financial analysis for measuring the distress. Corporate bankruptcy occurs when stock holders

exercise their right to default. That right is valuable when a firm gets into trouble.

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REFERENCES:

ARTICLES:

"A Further Empirical Investigation of the Bankruptcy Cost Question," Journal ofFinance, vol.39, pp. 1067-1089

The Cost of Bankruptcy: A Review," International Review of Financial Analysis, vol. 11,pp. 39-57

The Risk-Adjusted Cost of Financial Distress Heitor Almeida and Thomas Philippon Altman, Edward, 1984, A Further Empirical Investigation of the Bankruptcy Cost

Question, Journal of Finance 39, 1067-1089.

WEBSITES:

http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page40.htm http://financial-dictionary.thefreedictionary.com/Direct+Costs+of+Financial+Distress http://portal.brint.com/ http://www.highbeam.com/doc/1G1-180797033.html

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