Question

Suppose a firm wants to expand and will need to take on considerable debt to increase its operations. The firm is very concerned about the effect of financial distress costs on the value of the stock. Discuss options the firm can use to reduce these costs and their impact on the firm's value.

Answer 1

Answer: It is very crucial decision to issue the shares or raising the funds through debt. Debt brings interest burden and obligation with it. Heavy debt in company's balance sheet is not good. Company has to pay interest on debt on regular basis though interest is a deductible expense.

Financial distress- It is a condition when company is not able meet its obligations and cannot generate the revenues.

Financial distress cost- It is the cost associated with financial distress when company is at the verge of bankruptcy.

Examples of financial distress costs- Are as following:

1. Higher cost of capital
2. Bankruptcy cost
3. Conflict of interest
4. Indirect cost
5. Distressed asset sales

Company has to sell its assets quickly to meet the distress cost and other obligations.

How to reduce financial distress cost- Company should use the optimum capital structure, an ideal capital mix that reduces the overall cost of capital of business. Too much debt and too much equity are not good. There should be ideal debt-equity ratio. Ideal debt equity ratio is 1 or below 1 that again depends upon industry to industry. Some industries have to have higher debt and some can operate with lower debt. Company should timely pay the interest expense so as to reduce the burden. A lower cost of capital increases value of firm.