Definition of 'Financial Distress' A condition where a company cannot meet or has difficulty paying off its financial obligations

to its creditors. The chance of financial distress increases when a firm has high fixed costs, illiquid

assets, or revenues that are sensitive to economic downturns. Investopedia explains 'Financial Distress' A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing additional capital will usually increase, making it more difficult and expensive to raise the much needed funds. In an effort to satisfy short-term obligations, management might pass on profitable longer-term projects. Employees of a distressed firm usually have lower morale and higher stress caused by the increased chance of bankruptcy, which would force them out of their jobs. Such workers can be less productive when under such a burden. Read more: http://www.investopedia.com/terms/f/financial_distress.asp#ixzz2FnHXHmVY Financial distress is a term in corporate finance used to indicate a condition when promises to creditors of a company are broken or honored with difficulty. If financial distress cannot be relieved, it can lead to bankruptcy. Financial distress is usually associated with some costs to the company; these are known as costs of financial distress .

Cost of financial distress

A common example of a cost of financial distress are bankruptcy costs. These direct costs include auditors' fees, legal fees, management fees and other payments. Cost of financial distress can occur even if bankruptcy is avoided (indirect costs). Financial distress in companies requires management attention and might lead to reduced attention on the operations of the company. Another source of indirect costs of financial distress are higher costs of capital as usually banks increase the interest rates if a state of financial distressed occurs

Options for relieving financial distress

If high debt burden is the cause of financial distress, the company can undergo a debt restructuring. If operational issues are the reason for the distress, the company can negotiate a payment holiday with its creditors and improve operations to be again able to service its debt.

External financing
From Wikipedia, the free encyclopedia

Jump to: navigation, search In the theory of capital structure, External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment. There are many kinds of external financing. The two main ones are equity issues, (IPOs or SEOs), but trade credit is also considered external financing as are accounts payable, and taxes owed to the government. External financing is generally thought to be more expensive than internal financing, because the firm often has to pay a transaction cost to obtain it.

The Management of Foreign Exchange Risk

by Ian H. Giddy and Gunter Dufey New York University and University of M ichigan
1 OVERVIEW. 1 (a) Goals of the chapter Exchange risk is the effect that unanticipated exchange rate changes have on the value of the firm. This chapter explores the impact of currency fluctuations on cash flows, on assets and liabilities, and on the real business of the firm. Three questions must be asked. First, what exchange risk does the firm face, and what methods are available to measure currency exposure? Second, based on the nature of the exposure and the firm's ability to forecast currencies, what hedging or exchange risk management strategy should the firm employ? And finally, which of the various tools and techniques of the foreign exchange market should be employed: debt and assets; forwards and futures; and options. The chapter concludes by suggesting a framework that can be used to match the instrument to the problem. 1 (b) What is exchange risk? Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Hitachi, the Japanese company, he or she will lose if the value of the yen drops. Yet from this simple question several more arise. First, whose gain or loss? Clearly not just those of a subsidiary, for they may be offset by positions taken elsewhere in the firm. And not just gains or losses on current transactions, for the firm's value consists of anticipated future cash flows as well as currently contracted ones. What counts, modern finance tells us, is shareholder value; yet the impact of any given currency change on shareholder value is difficult to assess, so proxies have to be used. The academic evidence linking exchange rate changes to stock prices is weak. Moreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms; in other words, that exchange risk is diversifiable. If it is, than perhaps it's a non-risk. Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward exchange

Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects currencies to go. And these contracts offer the ability to lock in the anticipated change. So perhaps a better concept of exchange risk is unanticipated exchange rate changes. These and other issues justify a closer look at this area of international financial management. 2 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK? Many firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. They make this decision for a number of reasons. First, management does not understand it. They consider any use of risk management tools, such as forwards, futures and options, as speculative. Or they argue that such financial manipulations lie outside the firm's field of expertise. "We are in the business of manufacturing slot machines, and we should not be gambling on currencies." Perhaps they are right to fear abuses of hedging techniques, but refusing to use forwards and other instruments may expose the firm to substantial speculative risks. Second, they claim that exposure cannot be measured. They are right -- currency exposure is complex and can seldom be gauged with precision. But as in many business situations, imprecision should not be taken as an excuse for indecision. Third, they say that the firm is hedged. All transactions such as imports or exports are covered, and foreign subsidiaries finance in local currencies. This ignores the fact that the bulk of the firm's value comes from transactions not yet completed, so that transactions hedging is a very incomplete strategy. Fourth, they say that the firm does not have any exchange risk because it does all its business in dollars (or yen, or whatever the home currency is). But a moment's thought will make it evident that even if you invoice German customers in dollars, when the mark drops your prices will have to adjust or you'll be undercut by local competitors. So revenues are influenced by currency changes. Finally, they assert that the balance sheet is hedged on an accounting basis--especially when the "functional currency" is held to be the dollar. The misleading signals that balance sheet exposure measure can give are documented in later sections. But is there any economic justification for a "do nothing" strategy? Modern principles of the theory of finance suggest prima facie that the management of corporate foreign exchange exposure may neither be an important nor a legitimate concern. It has been argued, in the tradition of the Modigliani-Miller Theorem, that the firm cannot improve shareholder value by financial manipulations: specifically, investors themselves can hedge corporate exchange exposure by taking out forward contracts in accordance with their ownership in a firm. Managers do not serve them by second-guessing what risks shareholders want to hedge. One counter-argument is that transaction costs are typically greater for individual investors than firms. Yet there are deeper reasons why foreign exchange risk should be managed at the firm level. As will be shown in the material that follows, the assessment of exposure to exchange rate fluctuations requires detailed estimates of the susceptibility of net cash flows to unexpected exchange rate changes (Dufey and Srinivasulu, 1983). Operating managers can make such estimates with much more precision than shareholders who typically lack the detailed knowledge of competition, markets, and the relevant technologies. Furthermore, in all but the most perfect financial markets, the firm has considerable advantages over investors in obtaining relatively inexpensive debt at home and abroad, taking maximum advantage of interest subsidies and minimizing the effect of taxes and political risk. Another line of reasoning suggests that foreign exchange risk management does not matter

because of certain equilibrium conditions in international markets for both financial and real assets. These conditions include the relationship between prices of goods in different markets, better known as Purchasing Power Parity (PPP), and between interest rates and exchange rates, usually referred to as the International Fisher Effect (see next section). However, deviations from PPP and IFE can persist for considerable periods of time, especially at the level of the individual firm. The resulting variability of net cash flow is of significance as it can subject the firm to the costs of financial distress, or even default. Modern research in finance supports the reasoning that earnings fluctuations that threaten the firm's continued viability absorb management and creditors' time, entail out-of-pocket costs such as legal fees, and create a variety of operating and investment problems, including underinvestment in R&D. The same argument supports the importance of corporate exchange risk management against the claim that in equity markets it is only systematic risk that matters. To the extent that foreign exchange risk represents unsystematic risk, it can, of course, be diversified away -- provided again, that investors have the same quality of information about the firm as management -- a condition not likely to prevail in practice. This reasoning is buttressed by the likely effect that exchange risk has on taxes paid by the firm. It is generally agreed that leverage shields the firm from taxes, because interest is tax deductible whereas dividends are not. But the extent to which a firm can increase leverage is limited by the risk and costs of bankruptcy. A riskier firm, perhaps one that does not hedge exchange risk, cannot borrow as much. It follows that anything that reduces the probability of bankruptcy allows the firm to take on greater leverage, and so pay less taxes for a given operating cash flow. If foreign exchange hedging reduces taxes, shareholders benefit from hedging. However, there is one task that the firm cannot perform for shareholders: to the extent that individuals face unique exchange risk as a result of their different expenditure patterns, they must themselves devise appropriate hedging strategies. Corporate management of foreign exchange risk in the traditional sense is only able to protect expected nominal returns in the reference currency (Eaker, 1981).