Financial Distress Cost

Financial Distress Cost

The cost of liquidation. Financial distress costs include fees for lawyers and money needed to file paperwork. They also include the losses incurred from slowing or ceasing operations.
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We define high (low) financial distress cost firms as the 250 firms with lowest (highest) Altman's Z-score.
Theory predicts that nonfinancial corporations might use derivatives to lower financial distress costs, coordinate cash flows with investment, or resolve agency conflicts between managers and owners.
If there are costs to using too much debt (for example, expected financial distress costs or personal taxes on interest income), then firms with the greatest benefit to shielding taxes (for example, firms facing higher income tax rates) should be the ones with the greatest incentives to use debt financing.
Because MIPS is equity with an after-tax cost similar to that of risky debt, issuing this security and using the proceeds to retire outstanding preferred stock enables us to isolate the impact of tax savings on common share value without the confounding influence of financial distress costs.
These explanations suggest firms use derivatives to lower nondiversifiable costs that associated with market frictions, such as taxes, financial distress costs, and external financing costs.
Direct financial distress costs have previously been examined by many authors (see, e.
Such divestments allow a firm to avoid both direct and indirect financial distress costs.
Examining the relation between asset characteristics and capital structures is, however, complicated by the fact that a firm,s vulnerability to financial distress costs is unobservable.
Sample firms also attempt to reduce indirect financial distress costs by [TABULAR DATA FOR TABLE 1 OMITTED] minimizing the disruption in normal business activities that can accompany a traditional Chapter 11 filing.
The liquidity ratio is documented to be positively related to these proxies of financial distress costs.
While disagreement persists about the magnitude of financial distress costs, almost all financial economists would agree that firms in financial distress experience some deadweight losses.
A second response to high financial distress costs is to limit the use of debt financing.

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