a. Explain the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (7 Marks)

b. Describe how interested parties, other than bondholders, will be affected by high financial gearing levels, and describe what protective measures they can take. (8 Marks)

(Total 15 Marks)

a. Main problems and costs of severe financial difficulties

  • Liquidity problems: Inability to pay short-term obligations.
  • Loss of customer confidence: Customers switch to competitors.
  • Supplier terms tighten: Higher costs or prepayments.
  • Direct costs: Legal, advisory fees for restructuring.
  • Indirect costs: Management time diverted, lost sales, employee morale low.
  • Bankruptcy costs: If liquidated, asset fire sale.
  • Agency costs: Conflicts between stakeholders.

(7 Marks)

b. Effects on other parties and protective measures

Shareholders: Dilution from new equity, lower dividends; protect by voting rights, covenants.

Employees: Job losses, wage cuts; protect by unions, employment contracts.

Suppliers: Delayed payments; protect by short-term contracts, security.

Customers: Product quality decline; protect by warranties, diversification.

Government: Tax losses; protect by regulations.

(8 Marks)