© 2000 John Petroff
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© 2000 John Petroff |
2)- Potential default
The real danger is that a sales slump may last so long that the company will not be able to pay interest or other fixed charges. Naturally, the potential for default is not caused by the capital structure, but by a drop in cash flows. Plans are made with optimistic outlook of sales growth, or at worst steady sales. But, business cycles and aggressive competitors are ever present. Losses resulting from a shortfall in sales can be absorbed one year if the company has sufficient liquid assets to fall back on. But, if losses continue for another year or more, default on debt becomes more likely. That is why sales and profits variability discussed in the previous section, contributes to the potential for default.
There are several reasons why the mere potential for default is a significant risk burden. First the debt imposes fixed obligations that must be met. Even a small downturn in sales revenue can precipitate a default, and its harmful consequences. First, meeting the terms of existing loan covenants becomes a priority that restricts corporate strategy. Second, the reduction in flexibility is especially limiting for the need to undertake innovations that are by nature risky. Indeed, the firm must avoid taking on additional risk for fear of default in case innovations turn out to be unsuccessful. (One will recall that without a continuous effort to innovate, the firm cannot serve its clients as well as it should, and as well as its competitors are likely. Innovations are still necessary but become excessively risky as a result of financial leverage.) Third, the more a firm must borrow, the more lenders will raise interest and dictate restrictions of what the firm can do (e.g. not taking on more debt, not selling assets, not undertaking risky projects, and so on). Thus, financial leverage is a burden. The combination of restrictions put on the firm by the potential default and the additional interest charged by lenders is called bankruptcy cost. At this point, it is a bankruptcy cost in its mildest form.
See review questions Q-11C2.1 and Q-11C2.2.
See research assignment R-11C2.1.
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