Accounting and financial management 4 Topics Assignment

Accounting and financial management 4 Topics - Assignment Example Financial distress is a state whereby a company is not able to meet the agreements it had with its creditors it normally results to a company being termed as bankrupt. Cost associated with financial distress are normally termed as costs of financial distress. Some of the costs of financial distress are classified into direct and indirect. Direct cost include; legal fees, auditors fees, management fees. Some of the indirect costs involved are, loss of goodwill, loss of trust by creditors, loss of customers. Method 2: the second method is used only when the risk imposed on a company remains the same as a result of its capital structure, the company is ready to incur as much debt as possible. The main aim of this method is to identify the level of debt at which the advantages of increased debt are not outweighed by the increase in risk that are financially distressed company is subjected to. It is also known as the intuitive view. The theory indicates that a firm should have as ideal level of gearing at which its WACC is minimized. Nevertheless this theory does not indicate where the ideal level is and this leaves trial and error as the sole method of finding it. When gearing levels are low shareholders regard risk increases as marginal. This results to cheapness of debt issues and this causes WACC to be lower. When gearing ratios are higher the volatility of shareholders returns increase. Dominance in cheapness of extra debt results in WACC increasing as the levels of gearing increases. In the case when the levels of gearing have escalated abnormally both equity and debt holders face a risk of bankruptcy as a result the cost of equity and the cost of debt rise with increased gearing and this therefore causes WACC to rise further They disregarded the capital structure which was irrelevant in determining the cost of capital. They argued that a firm have no optimal value and its value is determined by the business risk it