Analysis of the Costs of Financial Distress and Status Quo in the Examination of this Costs Question

'Analysis of the Costs of Financial Distress & Status Quo in the Examination of this Costs Question'

General Discussion:

(Financial distress is a condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors. It is a term incorporate finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. If finance related distress cannot be relieved, it can lead to bankruptcy. It is usually associated with some costs to the company. The chance of such distress increases when a firm has high fixed costs, illiquid assets, or revenues that are sensitive to economic downturns.)

Besides direct fees for professional assessment and other charges incurred by the renegotiation of debt, finance related distress has hidden, so-called indirect costs. Indirect costs are defined as lost opportunities which the company misses as a result of a deteriorating solvency position. While lost opportunities can material in lost sales, decreased productivity, and losses of market positions, their roots are hidden in the sources of such distress, such as a sub-optimal allocation of resources, asymmetric information, and the conflict-of-interest problem. These costs are unobservable and difficult to estimate.

There are two main questions concerning the estimation of these costs. Those are

(i) The first one is more generic: How should this distress costs be valued?

(ii) The second problem is more challenging: What is the correct way to select which losses are born exclusively of this distress?

The primary subject of the analysis in this section is costs and their components which arise in the firm or business if and only if it enters financial distress. Current developments of related theories and researches examining determinants and attributes of distress costs, discuss the distinction between direct and indirect costs, introduce results of empirical studies on their magnitude, and answer the question about the impact of financial distress costs on corporate value. Since this direct financial distress costs occur only at the time of legal bankruptcy or renegotiation of debt out of court, the largest part of this section deals with the concept of the indirect costs of financial distress.

The Status Quo in the Examination of this Costs Question:

Traditionally, these costs attract the attention of researchers investigating the matters of corporate valuation and capital structure decisions. Central questions debated in this field are addressed to the proper measurement and the determinants of this costs and whether the magnitude of typical financial distress costs is significant such that they should be introduced into theoretical models of corporate valuation and capital structure decision-making. Another important question studied in the theoretical literature is what the upper and lower bounds of distress costs are and how high marginal distress costs can be.

Since financial distress costs do not accrue if the company is healthy, they have special properties distinguishing them from the usual cost of capital of sound firms. Unlike cost of capital, distress costs are time varying. This in turn has implications for their dynamics.

Distress costs have a long-term nature both simple and complicated. They are incurred on every stage of the corporate financial distress cycle.

However, in their dynamics, distress costs are non-monotonic and non-linear. Empirical investigations show that while approaching default a company experiences a sharp increase in distress costs, and the closer the firm comes to default, the larger the costs are and the more dramatic the value impairment compared to the pre-distressed level.

Another important consequence of the time-variation and non-linearity of this cost is that they tend to increase in recessions, which stresses the dependence of this costs on macroeconomic shocks and default risk.

In addition, a large portion of these costs is unobservable, which makes it difficult to estimate the real magnitude of these costs and to make suggestions about a going concern value.

Distress costs are insufficiently studied in financial literature. Given that direct costs of financial distress are relatively low in percentage terms of the pre-distressed value and happen only once when a company defaults and renegotiates its debt, the examination of indirect costs should be the subject of more extensive research, because these costs are hardly predictable and their amount is not fixed. Bankruptcy costs represent only a small fraction of finance related distress costs, whereas total indirect costs tend to be large and arise independently of the incidence of default.

The difficulties incurred by the estimation of distress costs are linked to a lack of general understanding concerning which individual pieces, aside from the reported costs of bankruptcy, constitute their total amount. Recent empirical studies shed light on the magnitude and determinants of distress costs. In these studies, indirect costs are very often determined as opportunity or dead-weight losses which include the decline in market share, decreased productivity, reduced capital expenditures, sale of assets at lower prices, and restrictive terms from suppliers.

In addition to specification of indirect losses happening in financial distress, several researchers have developed theoretical models isolating indirect distress costs and analyzing their indicators. The main problem in this context is whether the poor operating performance of a company is a cause or a consequence of financial distress. In order to overcome this dilemma, many researchers assume that the poor operating performance is a source of financial distress.