Cost of financial distress
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 or Insolvency costs.