CF chapter 16 Flashcards
Financial distress
When a firm has difficulty meeting its debt obligations
Default
When a firm fails to make the required interest payments on their debt
After the firm defaults, debt holders are given certain rights to the assets of the firm and may even take legal ownership of the firm’s assets through bankruptcy.
two ways a firm deals with bankruptcy:
Liquidation:
All company assets are sold
Proceeds of liquidation are used to pay back creditors
Reorganization:
More common for large organizations
Firms existing management is given the opportunity to propose a reorganization plan
Three key factors determine the present value of financial distress costs
- The probability of financial distress
- The magnitude of financial distress costs
- The discount rate for financial distress costs.
Optimal Capital Structure:
The Trade-Off Theory
According to the trade-off theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs
Trade off theory: Value of a levered firm V^L
V^L = V^U + PV(interest tax shield) - PV(financial distress costs)
Asset substitution
-you pay the current value of the assets (V0)
-you get a distribution of possible outcomes for the new project (V1).
To decide if the firm as a whole is better off
by engaging in asset substitution, you have
calculate the NPV:
NPV = -V0 + 1/(1+r) *E[V1]
V0 = value of the asset
V1 = possible outcome of the project
Agency Costs and an extended Trade-Off Theory:
Value of a levered firm V^L
V^L = V^U + PV(Interest tax shield) - PV(Financial distress costs) -PV(Agency costs of debt) + PV(Agency benefits of debt)
Q. How can you investigate whether it is true
that certain types of debt, such as bank debt,
have agency benefits?
A: You can run an event study:
-Identify two identical firms A and B, that only differ because one of them, firm B, gets a bank loan.
-study how the stock price reacts to the unanticipated announcement that firm B has gotten the loan
Too little vs too much leverage in a firm
Too little:
Lost tax benefits
Excessive perks
Wasteful investment
Empire building
Too much:
Excess interest
Financial distress costs
Excessive risk taking
Under investment
How can we mitigate agency?
– Short-term debt is associated with more oversight of managerial actions by creditors (banks).
- More generally, managers appear to misbehave when there is a lot of cash (ready for use in wasteful activities). So any activity (like debt-related payments) that reduces cash abundance, can mitigate empire building.
