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Which of the following companies is likely to incur higher cost of financial distress in an economic downturn? Justify your answer
Which of the following companies is likely to incur higher cost of financial distress in an economic downturn? Justify your answer.
Company A: A one-year old bio-tech company. So far, none of the company’s product has been approved for sale, but its scientists are working very hard in developing a breakthrough drug.
Company B: An oil and gas company. The company has 50 producing wells and 20 million barrels of
proven oil reserves.
Expert Solution
Cost of financing is usually a function of the risk involved in the underlying investment. For a bank to fund a particular firm, they will look at the risk profile and the quality of the collateral given by the firm.
Company A is likely to not have a lot of tangible assets, since it is still in development phase and has a high risk profile attached to it. If in the event the company does not get it right, the bank will have a high risk on the investment and hence they will look for a higher rate of return.
Whereas Company B, looks to be an established firm with significant assets in its name which can be used as collateral, hence the bank will charge a lower rate to this firm.
Hence Company A will have a higher cost of financing
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