Download Understanding Financial Distress and Indirect Bankruptcy Costs in Business and more Quizzes Corporate Finance in PDF only on Docsity! TERM 1 Economic Distress DEFINITION 1 -A firm experiences problems with the factors of operating income (ie. sales, revenues, costs) -Firm value will drop significantly. TERM 2 Financial Distress DEFINITION 2 -A condition when promises to creditors of a company are broken or honored with difficulty. -Must have debt in capital structure TERM 3 Direct Bankruptcy Costs DEFINITION 3 -Costs that are directly associated with bankruptcy, such as legal and administrative expenses. -Studies show that direct bankruptcy costs are likely small relative to firm value. TERM 4 Indirect Bankruptcy Costs DEFINITION 4 -Costs of avoiding a bankruptcy filing that are incurred by a financially distressed firm. -"The reduction in firm value caused by more or less predictable changes in corporate investment policy that occur when companies get into financial difficulty." -Barclay, Smith, & Watts TERM 5 Types of Indirect Bankruptcy Costs: Loss of competitiveness of a product/service market DEFINITION 5 -Foregone positive NPV investments because firm lacks financing. Especially relevant for firms whose value is primarily due to investment growth opportunities. -Selling valuable assets at "fire sale" prices. -Competitors may introduce new products or lower prices on existing products in an attempt to "squeeze" a distressed firm. TERM 6 Types of Indirect Bankruptcy Costs: Concessions to stakeholders DEFINITION 6 -Rework contracts with suppliers because many will refuse to go into long-term deals. -Unable to retain employees or attract new employees due to lack of job security. -Lost sales if customers doubt quality. -Creditors may seek bankruptcy to recover investment while shareholders try to avoid bankruptcy by dissipating the firm's assets. TERM 7 Firm Value: The Tradeoff Theory DEFINITION 7 -Factors influencing financial distress costs are probability of distress and magnitude of the costs to a distressed firm. -At low levels of debt, the interest tax shield outweighs financial distress costs. -Optimal capital structure: marginal tax shield=marginal financial distress costs. TERM 8 Factors that increase probability of distress DEFINITION 8 -Cyclical variation in demand (Heavy machinery, luxury retailers, restaurant dining, housing, auto industry) -Product market competition (Electronics, technology) -Reliance on volatile input/output commodity prices (Energy, refineries, chemical, jewelry) -Stage of industry life cycle (growth and decline stages) TERM 9 Factors that decrease probability of distress DEFINITION 9 -Firm size and diversification -Stage of industry life cycle (mature stage) TERM 10 Factors that increase magnitude of financial distress costs DEFINITION 10 -Growth opportunities (Biotech) -Reliance on intangible assets (Investment banks, software developers, consulting) -Products that require repair (Auto) -Products for which quality is important but hard to predict (Airline) -Products with high switching costs to customers (Cell phones, computer systems) -Products that depend on complementary products produced by other firms.
