Financial distress costs

Financial distress costs

Legal and administrative costs of liquidation or reorganization. Also includes implied costs associated with impaired ability to do business (indirect costs).

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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16) As financially distressed firm may lose customers, suppliers, and/or employees depending on the characteristics of their products and labor contracts for example, financial distress costs are also assumed to be heterogeneous across firms in Purnanandam (2008).
Such a situation allows them to limit their financial distress costs (Frank & Goyal, Journal of Financial Economics, 2003) and to benefit from a tax advantage owing to the deductibility of a fictitious and undisbursed interest expense.
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.
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.
When combining direct financial distress costs which primarily include the administrative costs, unpaid taxes/employee compensation and indirect financial distress costs which include the deterioration of the asset value and the loss of profitable opportunities, the estimates are indeed widespread: Warner (1977) reports that direct bankruptcy costs are 4% of market value one year prior to bankruptcy [J.
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.

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