Cost of Financial distress HW:
In tough economic times, companies must figure out new ways to generate income and cut costs. While assets don't cost more because a company is in financial distress, money borrowed to finance the assets may be more expensive.
It is not uncommon for financial institutions and banks to increase the rate charged for borrowed funds when a company is in financial distress. The difference between the new and old cost of funds is the cost of financial distress.
Show all formulas used and step by step
explain logic behind answer
Example:
Assume the interest rate paid to investors for a high credit quality bond (AAA) is 6 percent. What is the cost of Financial Distress to XYZ Company?
XYZ company has $1 million in loans and the interest rate for $250k has been raised to 8 percent due to financial distress and the interest rate on the other loan for $750k has been raised to 10 percent due to financial distress.
Step 1: Calculate the Weighted Average Interest Rate (WACC) on the Debt:
Step 2: Subtract the cost of debt for the AAA rated company from the weighted average cost of debt for your company:
Step 3: Calculate the cost of financial distress in dollar terms.