Base rate and Cost of financial distress: Difference between pages

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1. ''Reference rates''.
''Corporate finance''.


Generally, a base rate is a widely recognised and quoted interest rate - such as the Fed funds rate, the prime rate, or LIBOR - by reference to which a rate of interest is calculated.  
According to Modigliani and Miller's theory, as a company’s capital structure is composed of more and more debt a point is reached where equity cost and debt cost increase beyond that predicted by pure arbitrage of the appropriate cost of capital for the business. 
This extra cost is described as the cost of financial distress; potentially the cost of dealing with a near-insolvency situation.


More properly, these are a "reference rate" or a "benchmark rate". These terms avoid confusion with Base Rate (see below).
Financial distress costs can include:
* Higher rates of interest payable on borrowings.
* Additional fees payable on new borrowings.
* Additional restrictive covenants for new borrowings.
* Reduced availability of borrowings.
* Reduced availability of trade credit.
* Management time and loss of operational focus through the additional communications needed with lenders.
* In the worst case, actual insolvency.


For example, in the phrase ‘LIBOR plus 50 basis points’, LIBOR is the base (reference) rate.
The point at which financial distress costs become significant can be difficult to predict with precision.
However it can be estimated by reference to industry norms for key financial credit assessment ratios such as interest cover and debt equity ratios.


At the point at which the borrower breaches the industry norm for key ratios, it is likely that significant financial distress costs will be incurred.


2. ''Central bank rates''.
Also known as Bankruptcy costs.
 
More particularly, a central bank rate may be known as Base Rate. 
 
This is normally the rate at which the central bank will lend overnight funds, commonly of a secured basis, to financial institutions.
 
By changing this Base Rate, the central bank may hope to influence market rates generally. It seems that anticipated changes to Base Rate are one of the largest influences on movements in general market interest rates between actual Base Rate changes<ref>Paul Mizen and Boris Hofmann [http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/2002/wp170.pdf "Working Paper No 170: Base rate pass-through: evidence from banks' and building societies' retail rates"], London, 2002, ISSN 1368-5562. Retrieved on 21 July 2014.</ref>.
 
 
Base Rates, if secured, are like the [http://www.federalreserve.gov/monetarypolicy/discountrate.htm discount rate] applied to loans to eligible institutions from the US Federal Reserve Banks under the primary credit program of their "discount window".
 


== See also ==
== See also ==
* [[Alternate Base Rate]]
* [[Debt equity ratio]]
* [[Benchmark]]
* [[Insolvency]]
* [[Forward guidance]]
* [[Interest cover]]
* [[LIBOR]]
* [[Modigliani and Miller]]
* [[Official Bank Rate]]
* [[Reference bank]]
 
 
==References==
 
<references />
 
[[Category:Manage_risks]]

Revision as of 11:53, 5 August 2013

Corporate finance.

According to Modigliani and Miller's theory, as a company’s capital structure is composed of more and more debt a point is reached where equity cost and debt cost increase beyond that predicted by pure arbitrage of the appropriate cost of capital for the business. This extra cost is described as the cost of financial distress; potentially the cost of dealing with a near-insolvency situation.

Financial distress costs can include:

  • Higher rates of interest payable on borrowings.
  • Additional fees payable on new borrowings.
  • Additional restrictive covenants for new borrowings.
  • Reduced availability of borrowings.
  • Reduced availability of trade credit.
  • Management time and loss of operational focus through the additional communications needed with lenders.
  • In the worst case, actual insolvency.

The point at which financial distress costs become significant can be difficult to predict with precision. However it can be estimated by reference to industry norms for key financial credit assessment ratios such as interest cover and debt equity ratios.

At the point at which the borrower breaches the industry norm for key ratios, it is likely that significant financial distress costs will be incurred.

Also known as Bankruptcy costs.

See also

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