Question

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.

Answer 1

Answer:

ABC’s cash flows from operations are less volatile than XYZ’s

Distress Cost refers to expenses that a firm in financial distress incurrs beyond the cost of doing the business. It can be tangible and intangible. For eg. tangible - high interest rates etc. and intangible - loss of productivity etc. It has two categories : ex-ante ( before the event ) and ex-post ( after the event ).

Financial Distress refers to a condition in which an organisation , company or firm or an individual can't generate income or revenues or can't pay financial liabilities due to high fixed expenses.

Rising distress cost leads to bankruptcy and also loss of profitability. Company under distress find difficulty to secure financing and also face dropping of market value and share prices.

Generally Financial Distress is temporary. This allow the valuation to include discounted cash flow into the future. If company in financial problems, which are not temporary, this can affect company's terminal value. Non temporary financial distress is less common, then analyst find hard to evaluate the company. Then it is difficult to understand how distress will affect future cash flows.

A company or a business with asset heavy business model have more debt in comparison to asset light business model. For example Telecommunication companies, Power Distribution companies has more asset-heavy business model in comparison to software company.

Higher competitive business should have less debt and more stable business can have higher debt.