Financial distress
Financial distress arises when a firm struggles to meet its debt obligations. Resulting costs — customer defections, higher borrowing rates, management distraction and potential insolvency — are the force limiting debt in trade-off theory.
FrameworkCapital structure theory
What it is
See it move
The cost of financial distress has two parts. Direct costs are the legal and advisory fees of a bankruptcy proceeding, typically estimated at two to five per cent of firm value. Indirect costs are usually larger: customers defecting to stronger suppliers, creditors charging higher interest for the default risk, key employees leaving and management distracted from running the business.
Check yourself
A well-known electronics retailer shows clear signs of financial distress following a surge in leverage. Which of the following consequences is best classified as an indirect cost of financial distress?