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?

Solutions

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 2 months ago

Next > < Previous

Related Solutions

Why are the indirect costs of financial distress likely to be more important than the direct...

Why are the indirect costs of financial distress likely to be more important than the direct costs of bankruptcy? (Choose the correct response.) A. Many indirect costs may be incurred even if the firm is not yet in financial distress, but simply faces a significant possibility that it may occur in the future. B. None of the above - both direct and indirects costs are equally important. C. Direct costs and costs to debt holders, whereas indirect costs affect both...

When considering the impact of distress costs on capital structure, which of the following facts should...

When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a lower target debt ratio than XYZ Corporation (all else equal)? ABC is an electric utility, and XYZ is a computer software firm. ABC’s assets have lower resale values than XYZ’s assets. ABC operates in a less competitive industry than XYZ. ABC’s cash flows from operations are less volatile than XYZ’s.

[Costs of Financial Distress] Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is...

[Costs of Financial Distress] Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies’ economists agree that the probability of the continuation of the current expansion is 80% for the next year, the probability of a recession is 20%. If the expansion continues, each firm will generate EBIT of $ 2.4 million. If a recession occurs each firm will generate EBIT of $900,000. Steinberg’s...

If we incorporate Financial Distress or Bankruptcy Costs and also Taxes, then we have altered the...

If we incorporate Financial Distress or Bankruptcy Costs and also Taxes, then we have altered the fundamental assumptions of Modigliani and Miller. Explain the relationship between leverage and capital structure under the new assumptions.

What is the optimal D/V ratio that minimizes the WACC with and without financial distress costs?...

What is the optimal D/V ratio that minimizes the WACC with and without financial distress costs? Explain why the cost of debt and the cost of equity increase as debt is added to the capital structure? Explain why our method of increasing the cost of debt is unrealistic and what could you do instead?

How can a company incur costs of financial distress without ever going bankrupt. What is the...

How can a company incur costs of financial distress without ever going bankrupt. What is the nature of these costs? Further, why might it make sense for a mature, slow-growth company to have a high debt ratio? How does the M&M Theory of Irrelevance play a role in a company’s decision regarding its capital structure? Is M&M applicable in the real world or is it only relevant in the realm of academia?

What other costs of financial distress can you think about, that would need to be managed...

What other costs of financial distress can you think about, that would need to be managed by the distress investor

Problem 15-6 Costs of Financial Distress Steinberg Corporation and Dietrich Corporation are identical firms except that...

Problem 15-6 Costs of Financial Distress Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 70 percent for the next year, and the probability of a recession is 30 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $4.0 million. If a recession...

Explain how a company can incur costs of financial distress without ever going bankrupt. What is...

Explain how a company can incur costs of financial distress without ever going bankrupt. What is the nature of these costs? Further, why might it make sense for a mature, slow-growth company to have a high debt ratio? How does the M&M Theory of Irrelevance play a role in a company’s decision regarding its capital structure? Is M&M applicable in the real world or is it only relevant in the realm of academia?

Do you think a corporation must actually declare bankruptcy to incur costs associated with financial distress?...

Do you think a corporation must actually declare bankruptcy to incur costs associated with financial distress? Could rumors of financial problems lead to costs? How would these costs lower firm value? Explain your answers.

Subjects