FINANCIAL DISTRESS AND AGENCY COST AND CAPITAL STRUCTURE FOR NET COMMERCE/MANAGEMENT

• BANKRUPTCY AND AGENCY COSTS
  FINANCIAL DISTRESS AND CAPITAL STRUCTURE FOR NET COMMERCE/MANAGEMENT
  MEANING OF FINANCIAL DISTRESS

1. WHEN A FIRM USES MORE AND MORE OF DEBTS IN THE CAPITAL MIX THE FINANCIAL RISK OF THE FIRM INCREASES
2. MAY NOT BE ABLE TO PAY THE FIXED INTEREST TO THE SUPPLIERS OF DEBT AS THEY FORCE THE COMPANY TO LIQUIDATE
3. THE FIRM’S CONTINUOUS FAILURE TO MAKE PAYMENTS TO DEBT –HOLDERS CAN ULTIMATELY LEAD TO THE INSOLVENCY OF THE FIRM
4. WITH HIGH BUSINESS RISK AND HIGHER DEBT,THE PROBABILITY OF FINANCIAL DISTRESS BECOMES MUCH GREATER
5. THE DEGREE OF BUSINESS RISK OF A FIRM DEPENDS ON THE DEGREE OF OPERATING LEVERAGE ( THE PROPORTION OF FIXED COSTS),GENERAL ECONOMIC CONDITIONS,DEMAND AND PRICE VARIATIONS,INTENSITY OF COMPETITION,EXTENT OF DIVERSIFICATION AND THE MATURITY OF INDUSTRY

• COSTS OF FINANCIAL DISTRESS

1. MAY FORCE THE COMPANY TO INSOLVENCY
2. DIRECT COSTS OF FINANCIAL DISTRESS INCLUDE COSTS OF INSOLVENCY
3. THE PROCEEDING OF THE INSOLVENCY INVOLVE COMPLICATE AND LENGTHY PROCESS
4. THE CONFLICTING INTEREST OF CREDITORS AND STAKEHOLDERS CAN DELAY THE LIQUIDATION OF THE COMPANY’S ASSETS
5. ASSETS MAY HAVE TO BE SOLD AT DISTRESS PRICES WHICH MAY BE LOWER THAN CURRENT VALUES
6. THE EXPECTED COSTS OF INSOLVENCY RAISES THE LENDER’S REQUIRED RATE OF RETURN WHICH CAUSES A DAMPENING EFFECT ON THE MARKET VALUE OF THE EQUITY

• INDIRECT COSTS OF FINANCIAL DISTRESS

1. EMPLOYEES : BECOME DOMARLIZED AND THEIR EFFICIENCY AND PRODUCTIVITY DECLINE AND FOR THE BETTER FUTURE THEY START LEAVING THE ORGANIZATION AND IT WILL AFFECT THE REPUTATION OF THE FIRM AND SALE OF THE PRODUCTS
2. CUSTOMERS: DEMAND STARTED REDUCING AS THE CUSTOMERS FEAR THAT THE COMPANY WILL GO INTO LIQUIDATION
3. SUPPLIERS :DISCONTINUE GRANTING OF CREDIT
4. SHAREHOLDERS :-START BEHAVING DIFFERENTLY WHEN A FIRM IS UNDER FINANCIAL DISTRESS BUT NOT SOLVENT MAY BE TEMPTED TO UNDER TAKE RISKY PROJECTS AND IF SUCCEED THEN THEY WILL GAIN AND ON THE OTHER HANDS THE PROJECT FAILS THE CLAIMS OF THE CREDITORS REDUCES.
5. MANAGERS :-HAVE THE TENDENCY TO EXPROPRIATE THE FIRM’S RESOURCES IN THE FORM OF PERUISTIES AND AVOID RISK. WHEN THE FIRM IS UNDER FINANCIAL DISTRESS,THEY MAY POCKET THE FIRM’S RESOURCES AND START MAKING DECISIONS SHORT TERM BENEFITS  AND TRY TO CUT THE COST WHICH WILL AFFECT THE QUALITY. SURPASS THE PROFITABLE OPPORTUNITIES

• FINANCIAL DISTRESS THE REDUCES THE VALUE OF FIRM
• VALUE OF THE LEVERED FIRM=VALUE OF UNLEVERED FIRM + PV OF TAX SHIELD-PV OF FINANCIAL DISTRESS
• THE OPTIMUM POINT IS REACHED WHEN THE MARGINAL PRESENT VALUE OF THE TAX BENEFIT AND FINANCIAL DISTRESS COST ARE EQUAL AND THE VALUE OF THE FIRM IS MAXIMUM AT THIS POINT
• AGENCY COSTS

1. CONFLICT OF INTEREST AMONG SHAREHOLDERS,DEBT HOLDERS AND THE MANAGEMENT
2. CONFLICTS GIVE RISE TO AGENCY PROBLEMS WHICH INVOLVE AGENCY COSTS
3. WHEN A FIRM RAISES DEBT THE SUPPLIERS OF DEBT PUT RESTRICTIVE CONDITIONS IN THE LOAN AGREEMENT RESULTING INTO LESSER FREEDOM TO THE MANAGEMENT IN DECISION MAKING CALLED AGENCY COSTS
4. THE AGENCY COST RISE WITH THE INCREASE OF DEBT IN THE CAPITAL MIX AS MORE AND MORE RESTRICTIONS ARE PUT. THEY MAY PROVIDE THE DEBT AT HIGHER INTEREST AND HIGHLY LEVERAGED FIRM HAS MORE OF AGENCY COSTS AS COMPARED TO LOW GEARED FIRM.

• AGENCY COSTS
• SHAREHOLDERS –DEBT HOLDERS CONFLICT:-

1. DEBT HOLDERS HAVE A PREFERENTIAL BUT FIXED CLAIM OVER THE FIRM’S ASSETS
2. CLAIM OF SHAREHOLDERS IS RESIDUAL BUT UNLIMITED CLAIM ON THE FIRM’S ASSETS
3. LIABILITY OF THE SHAREHOLDERS IS LIMITED
4. IN FINANCIAL CRISIS THE SHAREHOLDERS CAN MOVE OUT FROM OWNING THE FIRM
5. BUT IN HIGHLY GEARED COMPANY THE RISK OF DEB THOLDERS IS VERY HIGH
6. THE CONFLICT BETWEEN SHAREHOLDERS ( OR MANAGERS WHO ARE WORKING ON BEHALF OF THE SHAREHOLDERS ) AND DEBT HOLDERS MAY ARISE BECAUSE OF THE POSSIBILITY OF TRANSFERRING THE WEALTH OF THE DEBT IN THEIR FAVOR

• SHAREHOLDERS-MANAGERS CONFLICT

1. SHAREHOLDERS ARE THE LEGAL OWNERS AND MANAGERS ARE REQUIRED TO ACT IN THEIR BEST INTERESTS
2. CONFLICT MAY ARISE:
3. MANAGERS MAY TRANSFER SHAREHOLDER’S WEALTH TO THEIR ADVANTAGE BY INCREASING THEIR COMPENSATION AND PERQUISITES
4. MANAGERS MAY NOT ACT IN THE BEST INTEREST OF THE SHAREHOLDERS

• MONITORING AND AGENCY COSTS
  
  
• ARISING FROM THE CONFLICTS BETWEEN SHAREHOLDERS,DEBT HOLDERS AND MANAGERS THROUGH MONITORING AND RESTRICTIVE COVENANTS
• INVESTORS KNOW THAT MANAGERS MAY NOT FUNCTION IN THEIR INTEREST,THEY DISCOUNT THEIR SECURITIES
• DEBT HOLDER PUT RESTRICTION ON THE FIRM IN TERMS OF NEW DEBT AND ALSO HIRE EXPERT TO EVALUATE THE SOUNDNESS OF THE FIRM AND MONITOR MECHANISM
• SHAREHOLDERS CREATE MANY MONITORING MECHANISM TO ENSURE THAT THAT MANAGERS SHOULD KEEP IN MIND THE MAXIMIZATION OF THE WEALTH OF SHAREHOLDERS

• THE IMPLICATION OF AGENCY COSTS
• THE COST OF MONITORING AND RESTRICTIVE CONDITIONS ARE CALLED AGENCY COST
• AGENCY COST OF THE DEBT TAKE ACCOUNT OF LIKELIHOOD OF EXPROPRIATE WEALTH
• AGENCY COST OF SHAREHOLDER GIVING INCENTIVES TO MANAGERS TO MOTIVATE THEM FOR MAXIMIZING THE WEALTH OF SHAREHOLDERS
• THE IMPLICATION OF AGENCY COSTS FOR CAPITAL STRUCTURE ARE THAT MANAGEMENT SHOULD USE DEBT TO THE EXTENT THAT MAXIMIZES THE WEALTH OF SHAREHOLDERS
• AGENCY COSTS REDUCE THE TAX ADVANTAGE OF THE DEBT