Question

Explain how financial distress cost is useful in explaining low leverage puzzle and the heterogeneity of leverages across the different industries.

Answer 1

Financial distress lead to huge problem in case of exposure to high leverage because in that case leverage will put more pressure on profitability which may lead to even more losses. To tackle this issue one has to be very careful while exposing its business to the leverage ,in case of low leverage of no leverage there is not much pressure on the profitability ratio of the business and not only that if rates increases it will not impact much to the profitability of the organisation. Thus in case of leverage one has to take care of financial distress cost because this may lead to higher probability of default and also lead to higher cost of capital.

Different industries have different requirement thus industry with huge amount of capital may require debt in its capital structure but it may lead to failure if company is not able to payback its debt or failed on interest payment which will again lead to higher cost of capital and increase in probability of default. Thus one has to very careful about the financial distress cost because it may lead to failure of the company in case of adverse economic and financial situations.