Cost of Financial Distress

8 Key excerpts on "Cost of Financial Distress"

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  eBook - ePub

  The Value of Debt

  How to Manage Both Sides of a Balance Sheet to Maximize Wealth

  • Thomas J. Anderson(Author)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  Financial distress is a term that defines the events preceding and including bankruptcy such as a violation of loan contracts. Financial distress is comprised of the legal and administrative costs of liquidation or reorganization (direct costs); and an impaired ability to do business and an incentive toward selfish strategies such as taking large risks, under-investing, and milking a property (indirect costs).

  Throughout this book, financial distress, when applied to individuals and families, will mean much the same thing. That is, an individual or family will be said to be in financial distress when the individual or family has trouble honoring financial commitments and paying bills, a situation that, if unrelieved, can lead to bankruptcy. Similarly, the costs of financial distress—which we’ll shortly look at in more detail as comprising both direct and indirect

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  The Role of Law and Regulation in Sustaining Financial Markets

  • Niels Philipsen, Guangdong Xu(Authors)
  • 2014(Publication Date)
  • Routledge

    (Publisher)

  Initially, the scope of the definition of distress costs only covered losses from liquidating a defaulting organization. In more recent literature, the concept of distress costs is usually understood as including a wide array of costly items also covering externalities from corporate defaults to society as a whole. 15 Today, it is commonly accepted in the literature that, in addition to the (direct) costs of bankruptcy statutory reorganizations or liquidations, the concept of distress costs also includes the types of (indirect) costs, both financial and economic, that companies and contracting parties experience in the vicinity of insolvency. 16 Much of the indirect distress costs arise in the form of contractual, formal or relational, precautions incurred by claimholders as soon as default gradually appears as a likelier outcome. As Cornaggia observes: “Indeed, distress is not best considered a binary state but rather a continuum of financial health. Many firms take actions that have wealth implications for employees, customers, suppliers, creditors, and shareholders long before default or bankruptcy” (Cornaggia 2011: 358). As explained by Myers (1977), the costs of financial distress are incurred when the firm comes under the threat of bankruptcy, even if bankruptcy is ultimately avoided. Examples of distress costs include the losses generated by workers withholding personal investments, by clients seeking alternative sources of supplies, by input providers bargaining for shorter terms, by creditors requesting security interests or collaterals from third parties, by the losses of reputation affecting market shares and in general, etc. Bargaining and other transaction costs incurred by prospective creditors in designing protective covenants against agency conflicts are to be listed among these indirect distress costs too

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  Risk Management in Public Administration

  • Konrad Raczkowski(Author)
  • 2016(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Financial distress prediction models are widely discussed in the litera- ture but little attention is paid to the associated costs. One of the most frequently cited results is the acknowledgment that financial distress costs are almost the same as the costs of bankruptcy. The financial literature has traditionally differentiated two types of financial distress costs: direct 324 M. Ziolo et al. and indirect. The problematic issue is the selection of appropriate tools for measuring these costs, especially in the case of indirect costs. Pindado and Rodriquez (2005) have pointed out that financial distress costs are determined by both the probability of a financial distress occurring and the ex-post financial distress costs experienced. They found that financial distress costs are positively related to the probability of a financial distress happening, and that the costs are negatively related to the leveraging and holding of liquid assets. The existent literature places great emphasis on minimizing the costs of financial distress and on the process of their elimination. Local gov- ernments must embrace the concept of prioritizing expenditures, main- taining fiscal transparency, and developing multi-year financial forecasts. Managers, policy makers, and department heads alike must undertake new and creative strategies in order to provide services in times when there is a perceived scarcity of resources (Powell 2013). One of the most important factor in budget proces is long-term forecasting. In particular, managers should see the consequences of today’s decisions in the future (Bahl and Schroeder 1984). Another important consideration was pointed out by Trussel and Patrick (2012), who assert that stakeholders play a primary role in avoid- ing financial distress. They argue that stakeholders can monitor the fiscal health of municipalities in order to prevent and mitigate fiscal distress but that they need reliable and efficient ways to do so.

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  Corporate Financial Distress

  Going Concern Evaluation in Both International and U.S. Contexts

  • Marisa Agostini(Author)
  • 2018(Publication Date)
  • Palgrave Pivot

    (Publisher)

  Therefore, corporate financial distress can be defined as a negative lasting situation during which a firm experiences bad financial conditions such as low liquidity, inability to pay debts, restriction on dividend distribution policy, increase in the cost of capital, reduction in access to external funding sources, and weaker credit ratings. Academic literature provides several examples of such financial consequences represented as negative (financial) accounting items, and these have been used as criteria in financial distress definitions. The most frequent examples are several years of negative net operating income, suspension of dividend payments, major restructuring or layoffs (Platt and Platt 2002), low interest coverage ratio, negative earnings before interest and taxes (EBIT), negative net income before special items, losses, selling shares to private investors, successive years of negative shareholders’ funds or accumulated losses (McLeay and Omar 2000), an increase in the cost of capital, a reduction in access to external funding sources, and weaker credit ratings. The negative consequences deriving from financial distress can be also differentiated according to the stage of enterprise life cycle. According to life cycle theory, growing capacity, access to resources, and strategies vary during a firm’s life cycle (Anthony and Ramesh 1992), which consists of four stages: birth, growth, maturity, and decline. In the early stages of its growth, firms are typically small, dominated by their owners (entrepreneurs), simple, informal in structure, undifferentiated, and with highly centralized power systems and considerable focus on innovation (Miller and Friesen 1984). Inevitably, these firms face significant uncertainty over future growth, which is manifested in higher book-to-market ratios and greater firm-specific risk (Pastor and Veronesi 2003)

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  Corporate Financial Distress

  Restructuring and Turnaround

  • Alberto Tron(Author)
  • 2021(Publication Date)
  • Emerald Publishing Limited

    (Publisher)

  Chapter 1

  Corporate Distress and Financial Equilibrium: Genesis and Prognosis

  1. Introduction and Background

  Research on financial distress and corporate crisis management is relatively young in comparison to studies on financially sound enterprises.

  The corporate health of firms is of considerable concern for various stakeholders, such as investors, managers, policy makers and industry participants. Nowadays, the main concern of companies, regardless of their size and sector, is the threat of insolvency.

  There are several reasons for this strong focus on preventing and mitigating a corporate downturn.

  Traditionally, financial economics literature has portrayed financial distress as a costly event, the possibility of which is important in determining firms' optimal capital structure (Opler & Titman, 1994).

  A company under financial distress is a company that is struggling with promises made to its creditors. Financial distress can be defined as the point where cash flows are lower than the firm's current obligations (Wruck, 1990).

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  Solomon's Knot

  How Law Can End the Poverty of Nations

  • Robert D. Cooter, Hans-Bernd Schäfer(Authors)
  • 2011(Publication Date)
  • Princeton University Press

    (Publisher)

  The firm’s main stakeholders are its managers, employees, stockholders, and creditors; other stakeholders include consumers, politicians, and communities. The resolution of financial distress alters the status and wealth of its stakeholders. In a distressed firm, these groups have different aims: managers and employees want to keep their jobs, shareholders want a high stock price, and creditors want full repayment of debts. Different stakeholders have different powers, and they often bargain with each other in an attempt to agree on how to resolve the firm’s distress.

  Their bargaining power partly depends on the terms of a resolution that judges or other state officials will impose if the stakeholders cannot agree. The laws affecting a state-imposed resolution include bankruptcy, contracts, finance, corporations, employment, and consumer protection. The formal law, however, is less effective in many poor countries than in rich countries. In some developing countries, bankruptcy law is so ineffective and costly that firms never use it to resolve their distress. Furthermore, politics pervades the resolution of financial distress in some countries. The problems of distressed firms, consequently, differ significantly in developed and developing countries. General principles about distressed firms require modification in light of the special problems of developing countries.

  Causes and Cures of Financial Distress

  A firm combines capital and ideas under managers. Failure in capital, ideas, or managers can cause financial distress. First, consider distress caused by inadequate capital in a firm with good ideas and managers. Even good managers often miscalculate the timing of the firm’s revenues and costs. Thus start-ups in Silicon Valley often underestimate how long they will lose money before turning profitable. Similarly, a downturn in the business cycle sometimes causes a temporary cash crisis in a successful firm. Or a successful firm may experience an unanticipated shock that demands immediate cash, as when OPEC increases oil prices. If capital runs short in a firm with good ideas and good managers, the firm should refinance by seeking additional funds or restructuring its debt to slow repayment.

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  Redefining Risk & Return

  The Economic Red Phone Explained

  • Jesper Lyng Jensen, Susanne Sublett(Authors)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  However, financial distress analysis is an investigative discipline that analyzes companies experiencing financial distress, such as a threat of bankruptcy, so this is not a generalisable method for calculating or pre- dicting the extra costs resulting from the sudden lack of capital because the lack of capital does not always lead to a threat of bankruptcy. This means that many other, more frequent, situations in which unexpected, significant needs for capital do not lead to a threat of bankruptcy are not included in the analysis of financial distress. Furthermore, the work is limited to companies and does not cover the financial situation of private individuals. What all the existing works on financial distress and shocks to capital and other specific fields in literature on capital have in common is that it is not possible to put these works into a specific, generalized, economic theory, as they are based on historic observations in specific and limited environments. Furthermore, the cost of running out of capital is not explained in economic literature on diversification. In this book, I have chosen not to go into detail on the cost of running out of capital as addressed in diversification literature because I would like to focus on insurance and capital as risk tools. This is because, in my view, the need to integrate the generalized cost of running out of capital is greatest in theories dealing with insurance and capital. This book describes basic, generalisable risk theory, which can be used to describe how and when extra costs associated with a risk event occur. The book addresses these points because the generalized theory allows for understanding and insight, which we cannot achieve by analysing specific environments, and we may use this insight to develop a better, objective Redefining Risk & Return: The Economic Red Phone Explained 33 understanding of the possible situation in which a risk owner is exposed to risk.

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  Distress Risk and Corporate Failure Modelling

  The State of the Art

  • Stewart Jones(Author)
  • 2022(Publication Date)
  • Routledge

    (Publisher)

  These inputs have to be estimated each year, since the probabilities and the cash flows are likely to change from year to year. The adjustment for distress is a cumulative one and will have a greater impact on the expected cash flows in the later year. 23 Another approach is to adjust for distress through the discount rate. Under this approach, one could estimate the cost of equity, using a beta more reflective of a healthy firm in the business, and then adding an additional premium to reflect distress as shown in equation 1.2. Cost of equity = Riskfree Rate + BetaHealthy(Equity Risk Premium)+ Distress Premium The distress premium can be estimated in 1.2 by either examining historical data on returns earned by investing in the equity of distressed firms or comparing the company’s own pre-tax cost of debt to the industry average cost of debt. An alternative to the modified discounted cash flow model is to separate the going concern assumptions and the value that emerges from it from the effects of distress. 24 Financial analysts also need to understand the distress implications involved in forming earnings forecasts and stock recommendations. As mentioned earlier, the Dodd–Frank Wall Street Reform and Consumer Protection Act (2010) contains several requirements (mainly soliciting studies and reports) relating to potential conflicts of interests among analysts. In the context of widespread public criticism of analysts, Clarke et al. (2006) considered the extent to which analysts are reluctant to issue negative recommendations in distressed firms because of the potential loss of future investment banking deals. They argued that such behaviour is expected to produce positive biases in analyst recommendations (i.e., overly optimistic recommendations). Their second question concerned the potential for conflicts of interest among analysts that have ongoing business dealings with a firm

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