What is meant by financial distress? And what are the direct and - ProProfs Discuss
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What is meant by financial distress? And what are the direct and indirect costs of bankruptcy?

Asked by Mtnjounkwe, Last updated: Jul 18, 2024

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mtnjounkwe

mtnjounkwe

mtnjounkwe
Mtnjounkwe

Answered Jun 04, 2020

Financial distress: where the obligations to creditors are not met or are met with difficulty. Direct costs are potential legal and administrative costs. These are the costs associated with the litigation arising from a liquidation or bankruptcy. These costs include lawyers fees, courtroom costs, and expert witness fees. Indirect costs include the following: 1) Impaired ability to conduct business. Firms may suffer a loss of sales due to a decrease in consumer confidence and loss of reliable supplies due to a lack of confidence by suppliers. 2) Incentive to take large risks. When faced with projects of different risk levels, managers acting in the shareholders interest have an incentive to undertake high-risk projects. Imagine a firm with only one project, which pays 100 in an expansion and 60 in a recession. If debt payments are 60, the shareholders receive 40 (= 100 60) in the expansion but nothing in the recession. The bondholders receive 60 for certain. Now, alternatively imagine that the project pays 110 in an expansion but 50 in a recession. Here, the shareholders receive 50 (= 110 60) in the expansion but nothing in the recession. The bondholders receive only 50 in the recession because there is no more money in the firm. That is, the firm simply declares bankruptcy, leaving the bondholders holding the bag. Thus, an increase in risk can benefit the shareholders. The key here is that the bondholders are hurt by risk, since the shareholders have limited liability. If the firm declares bankruptcy, the shareholders are not responsible for the bondholders shortfall. 3) Incentive to under-invest. If a company is near bankruptcy, shareholders may well be hurt if they contribute equity to a new project, even if the project has a positive NPV. The reason is that some (or all) of the cash flows will go to the bondholders. Suppose a property developer owns a building that is likely to go bankrupt, with the bondholders receiving the property and the developer receiving nothing. Should the developer take 1 million out of his own pocket to add a new wing to a building? Perhaps not, even if the new wing will generate cash flows with a present value greater than 1 million. Since the bondholders are likely to end up with the property anyway, the developer will pay the additional 1 million and likely end up with nothing to show for it. 4) Milking the property. In the event of bankruptcy, bondholders have the first claim to the assets of the firm. When faced with a possible bankruptcy, the shareholders have strong incentives to vote for increased dividends or other distributions. This will ensure them of getting some of the assets of the firm before the bondholders can lay claim to them.
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