Question

1. Although the major benefit of debt financing – the tax shield - is easy to calculate, many of the indirect costs of debt financing can be quite subtle and difficult to quantify. They arise, among other reasons, due to the loss of employees, fire sales of assets, and loss of customers in highly levered firms. Explain how these losses arise and which kind of companies are more affected; examples are going to be appreciated.

Answer 1

Excess debt financing can increase distress cost which are indirect costs of debt. As leverage in the company increases the time interest coverage ratio decreases and it becomes difficult to service debt, This makes the company less credit worthy and as a result risk in the company increases. This reduces the credit rating of the company. All these result in increase in cost of incremental debt and increases the cost of capital to the company. To service debt companies might have to fire employees , reduce operation, sell inventories ,etc. These create losses.
Example. The collapse of Lehmann brother occurred due to excessive leverage.Excessive leverage caused the company to collapse during recession as it could not service its debt and collapsed.