Financial distress

The term cost of financial strain describes in the field of corporate finance direct and indirect costs of a company in an economic tense situation. A simple example of costs of financial strain are bankruptcy costs. These so-called direct costs include legal fees, payments to a liquidator and other payments. However, costs of financial strain may also arise if a bankruptcy can be avoided (indirect costs ).

Direct costs

Among the direct cash costs of financial strain include:

  • Administrative expenses
  • Expenditure on consultancy services

Indirect costs

Indirect costs ( opportunity costs) of financial strain include:

  • The decline in demand associated with the economic situation
  • Increase in production costs due to rising input prices (suppliers as investors demand a higher risk premium )
  • Restructuring process and negotiations bind management performance
  • Loss of economic autonomy in insolvency proceedings

Effects

Financial strain can result in companies means that the efficiency of the management is reduced. Since the management the shareholders to be responsible, management strives to maximize the market value of equity. Under financial strain may contradict the goal of maximizing enterprise value of this goal because creditors are served in the case of a resolution first.

Decreases the value of the company falls below the value of the liabilities of the company, so it is in the interest of the shareholders, who now have nothing left to lose, that the company invested in risky projects, so that the probability increases that the company value rises above this value. However Risky projects are not in the interests of creditors, since they also increase the likelihood that the company's value drops further and remains them even less. Since these high-risk projects do not necessarily have a positive net present value, cost of unrealized gains may arise.

The management could also postpone a bankruptcy, which would have the same effect as an increase in risk or it could pay high dividends to transfer money from creditors to shareholders.

Indirect costs are also higher cost of capital. Short-term loans from banks or suppliers are expensive, if available at all.

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