21.5: Financial Distress, Bankruptcy, and Agency Costs

Question 1

What is bankruptcy?

Answer 1

Bankruptcy is a state of insolvency that occurs when a firm commits an act of bankruptcy, such as the non-payment of interest, and creditors enforce their legal rights to recoup money, or when a firm voluntarily declares bankruptcy in an effort to gain protection while it reorganizes so it can become solvent again.

Question 2

Define direct costs of bankruptcy.

Answer 2

Direct costs of bankruptcy are costs incurred as a direct result of bankruptcy, including liquidation of assets, the loss of tax losses, and legal and accounting fees.

Question 3

What are indirect costs of bankruptcy or financial distress costs?

Answer 3

Indirect costs of bankruptcy or financial distress costs are losses to a firm before it declares bankruptcy.

They occur when a firm is in financial distress, facing potential insolvency without taking corrective action, and include loss of reputation and disrupted operations.

Question 4

What is financial distress?

Answer 4

Financial distress is a state of business failure where bankruptcy seems imminent if dramatic action is not taken.

It involves a firm struggling to meet its financial obligations, risking insolvency.

Question 5

Define agency costs.

Answer 5

Agency costs are the costs associated with agency problems arising from the divergence of interests among managers, shareholders, and creditors.

They can include managerial behaviors that do not align with shareholder interests and conflicts between equity and debt holders.

Question 6

How does financial distress lead to value destruction in a firm?

Answer 6

Financial distress leads to value destruction by causing operational disruptions, reducing firm reputation, and forcing asset sales at distressed prices.

It increases costs and risks, leading to decreased investor confidence and potential loss of competitive position.

Question 7

What role do agency costs play in financial distress?

Answer 7

Agency costs increase during financial distress due to misaligned interests between managers and shareholders or creditors.

Managers might make decisions that benefit themselves at the expense of other stakeholders, exacerbating financial instability and reducing firm value.

Question 8

What is the static trade-off theory of capital structure?

Answer 8

The static trade-off theory of capital structure suggests that firms balance the tax benefits of debt against the costs of financial distress and bankruptcy to determine an optimal level of debt in their capital structure, maximizing firm value.

Question 9

How can a firm reduce agency costs during financial distress?

Answer 9

A firm can reduce agency costs by:

Implementing strong corporate governance to align managerial incentives with shareholder interests.

Establishing transparent communication with stakeholders.
Implementing performance-based compensation to incentivize managers to prioritize firm value.

Question 10

What is the Companies’ Creditors Arrangements Act (CCAA)?

Answer 10

The Companies’ Creditors Arrangements Act (CCAA) is a Canadian federal law that allows insolvent corporations that owe creditors more than $5 million to restructure their business and financial affairs while benefiting from protection against creditors.

Question 11

How does the Bankruptcy and Insolvency Act (BIA) differ from the CCAA?

Answer 11

The Bankruptcy and Insolvency Act (BIA) is generally used for smaller firms and is more rigid, offering limited scope for preventing creditors from seizing assets and emphasizing liquidation.

In contrast, the CCAA is more flexible and used mainly by larger firms needing reorganization.

Question 12

What are the implications of the static trade-off theory for a firm’s capital structure decisions?

Answer 12

The static trade-off theory implies that firms should weigh the tax benefits of additional debt against the increasing risk and cost of financial distress and agency costs, aiming to find a capital structure that maximizes overall firm value and minimizes total cost of capital.

Question 13

What is a call option in the context of shareholders and bankruptcy?

Answer 13

A call option in this context is the implicit right shareholders have to benefit from the upside potential of a firm while being protected from the downside risk due to limited liability.

The exercise price is equivalent to the firm’s debt, and the payoff is determined by the firm’s value exceeding this debt.

Question 14

How does limited liability affect shareholders during bankruptcy?

Answer 14

Limited liability allows shareholders to avoid personal liability for the firm’s debts beyond their initial investment.

This means that if the firm’s value drops below its debt, shareholders can walk away without additional losses, transferring the risk to creditors.

Question 15

Explain how a firm’s equity behaves like a call option in bankruptcy situations.

Answer 15

In bankruptcy situations, the firm’s equity behaves like a call option because shareholders can only gain if the firm’s value exceeds its debt.

If the firm’s value is below its debt, shareholders lose only their initial investment.

This option-like characteristic is due to limited liability and the potential for upside gain without further personal financial risk.

Question 16

What are the implications of treating equity as a call option for shareholder behavior?

Answer 16

Treating equity as a call option incentivizes shareholders to take on higher risk projects.

Since they do not bear further losses beyond their initial investment, they may favor riskier investments that could significantly increase the firm’s value, enhancing their payoff if successful.

Question 17

How does the risk of financial distress impact the value of equity as a call option?

Answer 17

The risk of financial distress increases the potential variability of the firm’s value, enhancing the value of equity as a call option.

Higher volatility increases the chance of the firm’s value exceeding its debt, providing more opportunities for equity holders to benefit.

Question 18

Describe the impact of time on the value of the equity as a call option.

Answer 18

The value of equity as a call option increases with time.

The longer the time horizon, the more opportunities there are for the firm’s value to exceed its debt, potentially resulting in a higher payoff for shareholders.

This time aspect increases the option’s value.

Question 19

How do creditors mitigate risks associated with shareholders treating equity as a call option?

Answer 19

Creditors mitigate risks by imposing covenants and restrictions on borrowing, requiring regular interest payments, and setting conditions for asset sales.

They aim to limit the firm’s ability to excessively increase risk, thus protecting their interests against the downside risk of shareholder behaviors that prioritize high-risk, high-reward scenarios.

Question 20

In the provided figure, how does the existence of limited liability affect the equity payoff?

Answer 20

In the figure, limited liability causes the equity payoff to remain at zero if the firm’s value is below its debt, and it rises only when the firm’s value exceeds its debt.

This illustrates how shareholders are shielded from losses beyond their initial investment but benefit from increases in firm value beyond the debt threshold.

Question 21

What happens to shareholders’ and creditors’ incentives when a firm enters financial distress?

Answer 21

When a firm enters financial distress, shareholders might pursue riskier projects since they are protected by limited liability.

In contrast, creditors bear more risk and may focus on recovering their loans, often resulting in a conflict of interest where creditors seek stability and shareholders seek upside potential.

Question 22

Why might shareholders prefer high-risk projects during financial distress?

Answer 22

Shareholders might prefer high-risk projects during financial distress because these projects offer the potential for significant returns.

If successful, they can restore the firm’s financial health and enhance shareholder value.

Since shareholders face limited downside risk, they are incentivized to gamble for potential large payoffs.

Question 23

What is the Static Trade-Off Theory?

Answer 23

The static trade-off theory states that a firm uses debt to maximize its tax advantages up to the point where these benefits are outweighed by the associated estimated costs of financial distress and bankruptcy.

Question 24

How does the M&M value of a levered firm take into account corporate taxes?

Answer 24

The M&M value of the levered firm considers corporate taxes by adding the tax shield to the value of the unlevered firm. The value increases with debt due to the tax shield benefit, up to the point where financial distress costs outweigh the tax advantages.

V_L = V_U + D*T

V_L = Value of the Levered Firm
V_U = Value of the Unlevered Firm
D = Debt
T = Corporate Tax Rate

Question 25

How is the optimal level of debt determined according to the static trade-off theory?

Answer 25

The optimal level of debt is determined where the slope of the financial distress curve equals the slope of the tax-corrected value line. At this point, the marginal benefit of the tax shield equals the marginal cost of financial distress and bankruptcy.

Question 26

What is the relationship between WACC and debt according to the static trade-off model?

Answer 26

Initially, as more debt is added, the WACC decreases due to the cheaper cost of debt compared to equity. However, beyond a certain point, depicted as (D/E) , the WACC begins to increase, reflecting higher financial distress and bankruptcy costs. The WACC is minimized at the optimal debt-to-equity ratio (D/E).

WACC = (E/V) * k_e + (D/V) * k_d * (1 - T)

WACC = Weighted Average Cost of Capital
E = Market Value of Equity
D = Market Value of Debt
V = E + D (Total Firm Value)
k_e = Cost of Equity
k_d = Cost of Debt
T = Corporate Tax Rate
D/E* = Optimal Debt-to-Equity Ratio

Question 27

How does the static trade-off theory explain the maximization of firm value?

Answer 27

According to the static trade-off theory, firm value is maximized at the optimal capital structure (D/E*) where the marginal tax shield benefit of debt is exactly offset by the marginal cost of financial distress and bankruptcy. Beyond this point, additional debt reduces firm value.