Financial Distress

cialDanielle Adams

FIN 3403-Extra Credit

Financial Distress

Financial distress is a term in Corporate Finance used to indicate a condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors. Sometimes financial distress can lead to bankruptcy. The chance of financial distress increases when a firm has high fixed costs, illiquid assets, or revenues that are sensitive to economic downturns. Financial distress is usually associated with some costs to the company; these are known as costs of financial distress.

A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing additional capital will usually increase, making it more difficult and expensive to raise the much needed funds. In an effort to satisfy short-term obligations, management might pass on profitable longer-term projects. Employees of a distressed firm usually have lower morale and higher stress caused by the increased chance of bankruptcy, which would force them out of their jobs. 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).

Companies in financial distress undergo corporate restructuring where valuations are used as negotiating tools. A traditional DCF valuation begins by projecting expected cash flows for a period (the value creation period). A continuing or terminal value at the end of the period captures what is believed the business will be worth at that point in time. The cash flows and continuing value estimates are converted to a present value at a discount rate that reflects the riskiness of the firm’s cash flows. Implicit in this approach is the assumption that the firm is a going concern with an...