Page 199 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Use covenants to align interests costs: monitoring to ensure they are followed; also may hamper
business. In essence, lost efficiency and monitoring costs reduce advantage of debt, given agency
costs and financial distress.
VL = VU + TD – (PV of expected costs of financial distress) – (PV of agency costs)

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8.9.3 Consequences of Financial Distress

Bankruptcy Costs

Specific bankruptcy costs include legal and administrative costs along with the sale of assets at
‘distress’ prices to meet creditor claims. Lenders build into their required interest rate the
expected costs of bankruptcy, which reduces the market value of equity by a corresponding
amount.

Indirect Costs

1. Investing in risky projects

2. Reluctance to undertake profitable projects
3. Premature liquidation
4. Short-term orientation

Debt Policy and Shareholders Conflicts

Shareholder-manager Conflicts

Managers have a tendency to consume some of the firm’s resources in the form of various
perquisites.

Managers have a tendency to become unduly risk-averse and shirk their responsibilities as they
have no equity interest, or when their equity interest falls. They may be passing up profitable
opportunities.

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