COSTS OF THE FINANCIAL DISTRESS

The costs of the financial distress and the legal proceedings under the code of the bankruptcy are important. For SME, the costs involved in the reorganization can often exceed the value of the firm, which explains the dissolution of this one.

Direct Costs

The direct costs of the financial distress are easier to measure. They include the legal, administrative and consultative fees paid by the company. The direct costs are essential for the companies which restructure their debts or those who go bankrupt. Numerous scientific studies tried to measure the direct costs of the bankruptcy. Altman (1984), White (1983) and Weiss (1990), assert that these direct costs represent approximately 3% of the market value of the company. In its study, War­ner (1977), shows that the clear amount of these costs was equal, on average, to 1% of the market value of the firm seven years before the failure and became a more and more raised percentage as the bankruptcy approached (for example, 2,5% of the value of the firm three years before the failure).

Real Costs Supported Directly by the Firm

They are all the spending of remuneration and fees of the external and internal services mobilized for realizing tasks of evaluation and judgment.

Fees of the Professionals

Generally, the failing firms resort to the services of the external professionals, in particular, the judicial experts, the chartered accountants and the listeners, the bankers’ investors, auctioneers and consultants. These fees are a function of the task to be made and of the complexity of the situation of the firm in trouble.

Weiss (1990) studied the direct costs for 37 situations of bankruptcy of the NYSE (New York Stock Exchange) and the AMEX (Ameri­can Stock Exchange) followed over the period from November, 1979 till December, 1986. He observed that these costs of bankruptcy are of the order of 3,1% of the book value of the debts and the market value of the actions(shares), a fiscal year before the period of bankruptcy. The results are similar to Altman (1984) and Warner (1977) over the previous periods.

Indeed, Warner estimated the costs of bank­ruptcy of the order of 4%, of the market value one year before the bankruptcy for a sample of 11 firms of the sector of railroads. Altman estimated costs of the order of 4,3% for a sample of 11 firms of the sector of iron paths and 7 industrial firms. A more recent study, by Betker (1997), noticed that the direct costs are of the order of 3,93%. Gilson and al. (1990), present a revealing of the direct costs of the private agreements. With a sample of 18 restructurings of debts, these authors show that the median of the direct costs of restructur­ing of the debt is 0,32%, the total of assets at the end of exercise.

Mobilization of the Staff

The process of resolution of the problems of bankruptcy requires not only the mobilization of the leaders in terms of time and energy, but also the implication of all the staff. Indeed, the firm owes make forehead for the problems generated by the bankruptcy, negotiate with his creditors to be able to develop a plan of reorganization, and to cooperate in communicator the necessary in­formation asked by the external professionals. All these tasks force the firm to keep its daily activity.

The internal costs launched during the process of resolution of the problems of bankruptcy, are implicit and difficult to estimate. The interaction between the staff of the bankrupt firm and the external professionals, implies an additional effort spread by the first part.

Real Costs Supported Directly by the Creditors of the Firm

Firms in situation of bankruptcy incur costs which are actually born by their creditors. So the shareholders, the bondholders, the bankers, the suppliers, the State, the retired people and the active employees, are forced to undergo the additional costs resulting from the common situ­ation of the firm.

Fees of the Professionals

The individual creditors, can support additional costs in the sense where they are going to delegate experts either to compose a legal advice separated to estimate and bound their legal positions in assets and liabilities of the failing firm. In several cases, the creditors are in front of certain complexities, they are going to ask a legal assistance or same to commit their own experts or bankers investors to represent them in the committees of the creditors and estimate their heritages.

Mobilization of the Staff

Several creditors commit their staff and other resources in the evaluation of their interests. A big part of their spending is bound to the exter­nal professionals, but the definitive decisions belong to them generally. For example, they have to sell or keep their parts? Do they have to vote for a rescue plan or for a plan of reorganization? Mostly, the creditors and especially the members of a minority party prefer to pursue the process of the bankruptcy.

After all, the management systems of the failing firms try to set up plans which allow protecting their jobs and the revenue streams of their credi­tors. Several of them prefer considerable changes in management systems considered initially less effective. The commercial, in particular the sup­pliers, prefer to protect their customer portfolio. As far as some groups defend their interests, other groups should support additional costs to maintain their relative positions. These additional resources are often directed to check the managers (Branch, 2002).

Reduction of the Commercial Efficiency

The creditors become more demanding when they notice that their debtor passes of a healthy situation in a situation of distress. This financial vulnerability is translated by two categories of loss:

• Their parts and profits tend to decrease in connection with the decreasing value of the firm.

• Their performances tend to degrade, in the presence of a loss of commercial efficiency of the firm further to a doubt on the growth potential of the exploitation.

Low liquidity of financial assets: listed securi­ties will become less liquid on the stock market and will more be explained to a slump in prices, which are translated by additional risks stemming from the degradation of the price ranges of the titles. Several firms in distress opt by the securitization of their claims or sign framework agreements with the companies of factoring.

Social climate: in several cases, the financial distress or the premature bankruptcy, lead to claim­ing of the creditors which can activate conflicts, because of the differences of interest which set them. The process of resolution of the problems is disrupted by the heterogeneous character of the interests of each, the degree of satisfaction, reac­tions and interpretations but also by the payability ofthe debts, what generates costs of opportunities.

They will thus be tried to fetch a safer employ­ment and to leave the company, which it, will have difficulty in inciting them to stay and to keep them. In the companies the activity of which depends on the human resources of certain employees, their departure can succeed to put the company to state of transfer of payment.

Losses of the Failing Firm Being Translated by Earnings for the Benefit of other Entities

The loss of performance for firms in distress can create opportunities for the competitors. So the losses of the bankrupt firm can be compensated, even partially, with gains for the benefit of other economic entities. These costs can take varied forms.

Loss of Market Shares

The disturbances caused by the bankruptcy will have generally effects opposite to the capacity of the firm to maintain and to increase its market share. Indeed, she begins by losing her brand image, her employees are less reassured and she becomes less capable of honoring her commit­ments. The financial distress affects its capacity to negotiate more favorable prices for the inputs as well as the terms of credit. Worried about the capacity of the failing firm, the suppliers often require a risk premium through higher price, or from lower-quality services. Besides, it is more difficult to negotiate favorable terms, prices and services, if the suppliers consider that their relation with the company is from now on of the short term and that the other entities of the market become prospects. This reality returns the other creditors less inclined to matter on the promises of the concerned company. So the skill of the bankrupt firm to develop stretchable business relationships will be more difficult. The market share is translated by an earnings for the benefit of one or several other economic entities, given that they share initially the totality of the profit of market.

Concentration on the Short Term

Because of their state of bankruptcy, firms cannot argue any more about the long term. They have to confine themselves to a short-term horizon. They need to keep funds to avoid any shortage on the long term and to bring to a successful conclusion their projects. A firm in situation of bankruptcy has no motivation to pursue opportunities on the long term which require financing and who are brought themselves to change immediately the horizons of reflection. They have to apply very high rates of updating for their future income.

Firms in situation of bankruptcy will always need, and under pressure of the creditors, to liquidate assets, (Shleifer and Vishny, 1992). These assets will generally have to be sold to market prices. The buyer is of this fact capable of exploiting the financial distress of the seller to negotiate assets at attractive prices. Moreover the more a firm is failing, the more it will be brought to liquidate assets to take funds, knowing that it focuses on the short term.

Firms in situation of bankruptcy, have to liquidate their assets, under the pressure of the creditors, (Shleifer and Vishny, 1992). These assets would as a rule be sold to the market price, but the buyers are going to tend to exploit the financial distress of the seller to negotiate the prices in the reduction. In fact, the more a firm is failing, the more it is led to liquidate assets to get itself funds essential to its survival, and it focuses of this fact on the short term.

As far as certain assets are less liquid, the failing firm has to support additional transaction costs, (Kim, 1996). Altman (1984), tried to estimate the indirect costs, by basing itself on the losses not anticipated for three years before the bankruptcy. His analysis implies indirect costs of 4,5%, for the commercial firms and 10,5% for the firms of the branch of industry. Wruck (1990), criticized the methodology of Altman of the fact that it is impossible to assert if the loss is caused in fact by the financial distress or if it is the financial distress which is the consequence of the loss. In another study of the indirect costs, to Opt and Tit­man (1994), showed that the firms of the extreme decile of debts incur 26% losses that the firms of the lowest decile of debts will have. The market value of their actions falls correlatively. The con­siderable positions which occupy the costs of the situation of failure, in particular for the common exploitation and for the processes of decision­making, imposes on any firm to be thought of developing a kind of dashboard to anticipate the situations of bankruptcy.

Indirect Costs

Contrary to the direct costs, the indirect costs are not observable and are thus difficult to specify and to measure empirically. However, the researchers developed various approaches used to analyze the likely scale of these costs. At first, it is difficult to distinguish if the bad performance of a company is caused by the indirect costs, or by the same factors which led her to a situation of financial distress. These studies thus tried to determine if the performance of the company reflects the costs of financial distress, the costs of the economic distress, or the interaction both. Altman (1984) was the first one to supply a methodology to measure the indirect costs of the bankruptcy. He notices that the average of the indirect costs is equal to 10,50% of the total value of the firm. The combination of both costs is estimated at 16,70% what is not unimportant with regard to the value of the firm. On the basis of valuable changes of the company in the course of time, the financial distress is considered from 10 to 20% of the value of the company. Andrade and Kaplan (1998), examines the qualitative aspects of behavior of companies. A great majority of firms are obliged to reduce their capital expenditures, to delay the restructuring, or to file for bankruptcy in a way which seems expensive.