Essay About Costs Of Financial Distress And Auto Industry

Chrysler Case
Chryslers capital structure considerations include the benefits of increased leverage and the negatives of increased leverage. The main benefit would be increased tax shields. From appendix B, the tax shield is 969.6. This is lower than years when the leverage ratio was higher. However, tax shields are most beneficial when a company has stable positive income, and Chrysler does not fit that description. In fact in some years with high tax shields, Chrysler made negative earnings. Therefore Chrysler might not be missing out on huge tax savings. Some of the risks are the costs of financial distress: the costs of financial advisors and legal costs in bankruptcy, and the fire sale of assets in bankruptcy. The auto industry is very cyclical so the probability of financial distress is high for Chrysler, and in fact in the past, Chrysler needed bailouts in the ‘70s and in the early ‘90s it was in financial trouble. The firm needs a lot of resources for R&D as evidenced in the early 90s when the company was not investing in new product development which increased the poor sales performance of the company. Chrysler would also face the cost of customers fleeing under financial distress because cars have warranties that consumers would be worried wouldnt be honored. Also, knowing the company is under financial distress may make costumers concerned about safety being affected by cost cutting. Employees might also leave the company under financial distress and the employees are important for product development. The auto industry is also very competitive and there could be a risk of price wars, as “incentive wars” are very prevalent in the industry. The time difference between the timing of sales and the accounts payable can also strain cash reserves and make having more cash on hand necessary.