3 Flashcards
What is financial distress
When a firm experiences significant problems in meeting it’s debt obligations
What is bankruptcy
Economically, firm goes bankrupt when value of its assets equal its debt therefore, equity has no value
What are the types of bankruptcy costs
Direct bankruptcy costs
Indirect bankruptcy costs
Financial distress costs
What is direct bankruptcy costs
Costs that are directly associated with bankruptcy such as legal and administrative expenses
What is indirect bankruptcy costs
Costs of avoiding a bankruptcy filing incurred by a financially distressed firm
What are financial distress costs
Direct and indirect costs associated with going bankrupt or experiencing financial distress
What are indirect costs of financial distress
Impaired ability to conduct business – suppliers and customers reluctant to do business
Agency costs – incentive to under investment. Incentive to take large risks
What are covenants
Legal agreement between Lender and borrower to protect borrower
What is static theory of capital structure
Firm borrows up to point where tax benefit from extra pound in debt is exactly equal to cost that comes from increased probability of financial distress
What are the rules of pecking order theory
Use internal financing – maximises management flexibility
Issue debt – tax shield
Issue equity – last resort
What are the implications of pecking order theory
No target capital structure
Profitable firms use less debt
Companies will want financial slack
What is market timing theory 
Managers issue equity when its market value is high relative to book values
Managers issued debt when market value of equity is low relative to its book values
Debt equity ratio is simply a function of past decisions and there is no optimal debt ratio
What is bankruptcy
Legal proceeding for liquidating or reorganising a business
What is liquidation
Termination of firm as a going concern
What is reorganisation
Financial restructuring of a failing firm to attempt to continue operations as a going concern
