Question

1. Although the major benefit of debt financing – the tax shield - is easy to calculate, many of the indirect costs of debt financing can be quite subtle and difficult to quantify. They arise, among other reasons, due to the loss of employees, fire sales of assets, and loss of customers in highly levered firms. Explain how these losses arise and which kind of companies are more affected; examples are going to be appreciated.

Answer 1

Many of the indirect expenses which are difficult to quantify and they are directly related to the debt financing and that could possibly be fire sale of asset, loss of employees, loss of customers.

Highly leveraged form uses a lot of debt to capitalise upon its growth rate because at the time of the economic boom, when the return on overall capital is higher than the overall cost of debt, it would be beneficial for the company to load on to lots of debt and it helps the company to gain a lot of market share.

But when the economic scenario change, and there is slowdown in the growth of the economy due to micro as well as macro factors,these periodic repayment associated with debt financing becomes a uphill task for these firms, as they are not able to repay there periodic obligations in form of interest so they increase upon cutting a lot of indirect costs which could be firing of the employees and fire sale of the asset to help them meet with their repayment schedule.

These companies overall profit goes down in changing adverse economic scenario, and they have to cut their cost but cost cutting has also limitation, so these debt obligation intensifies and that makes them lose consumers and the market.

it can will be seen through down cycles in economy when highly leveraged company falters first even after cutting onto majority of their indirect expenses by sale of Assets and filing of employees.