Financial Distress

Financial Distress Costs: 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): 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 and 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. Equally, management might choose to prolong bankruptcy, which has the same effect on probabilities of a change in the firm's value. Management might also distribute high dividends to "save" money from the creditors. Another source of indirect costs of financial distress are higher costs of capital: Short-term loans by contractors and banks are expensive and difficult to obtain. In finance, a company is considered to be in financial distress when it is having difficulty making payments to creditors. Financial distress may lead to bankruptcy. The more debt a company uses to finance its operations the more it is at risk of experiencing financial distress. There are several costs associated with financial distress, including bankruptcy costs, distressed asset sales, a higher cost of capital,...