Does it appear as if financial distress costs should be a significant determinant of Fortune 100...

Does it appear as if financial distress costs should be a significant determinant of Fortune 100 firms’ capital structures? What about for small growth firms?

Expert Solution

Fortune 100 firms have:

Operations generating healthy, stable cash flows
Access to operating cash flows good enough to service debt
High interest and fixed cost coverage ratios
Adequate size and strength to absorb fluctuation in businesses
Cost structure having higher proportion of variable cost

All of these put together imply a very low probability of financial distress and bankruptcy. Hence, the financial distress costs should not be a significant determinant of Fortune 100 firms’ capital structures.

Small growth firms have:

Higher operating leverage
Higher proportion of fixed costs in the cost structures
Relative less mature and hence more volatile cash flows
Lower ability to react and respond to adverse business conditions nd hence are not able to absorb shocks
Relatively poor debt service coverage ratio, interest coverage ratio and fixed cost coverage ratio

All of these put together imply a reasonably high probability of financial distress and bankruptcy. Hence, the financial distress costs should be a significant determinant of small growth firms’ capital structures.

jeff jeffy answered 8 months ago

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