Chapter 16 (1)

Question 1

workout

Answer 1

When a financially distressed firm is successful at reorganizing outside of bankruptcy

Question 2

Prepackaged bankruptcy

Answer 2

A firm will first develop a reorganization plan with the agreement of its main creditors and then file chapter 11 to implement the plan (and pressure any creditors who attempt to hold out for better terms) With a prepack, the firm emerges from bankruptcy quickly and with minimal direct costs

Question 3

Indirect costs associated with financial distress

Answer 3

Loss of customers

Loss of suppliers

Loss of employees

Loss of receivables (firms in financial distress tend to have difficulty collecting money that is owed to them, especially small amounts)

Fire sales of assets (in an effort to avoid bankruptcy and its associated costs, companies in distress may attempt to sell assets quickly to raise cash. To do so the firm may accept a lower price than would be optimal if it were healthy)

INnefficient liquidation (bankruptcy protection can be used by management to delay the liquidation of a firm that should be shut down, can lose money because management was allowed to continue making negative NPV investments )

Costs to creditors

Question 4

Debtor in possession financing

Answer 4

New debt issued by a bankrupt firm. Because this kind of debt is senior to alll existing creditors, it allows a firm that has filed for bankruptcy renewed access to financing to keep operating

Question 5

Overall impact of indirect costs

Answer 5

The indirecct costs of financial distress can be substantial. When estimating them, however, we must remember two important points

1. We need to identify losses to total firm value
2. WE need to identify the incremental losses that are associated with financial distress, above and beyond any losses that would occur due to the firms economic distress

Question 6

Trade off theory

Answer 6

The total value of a levered firm equals the value of the firm without leverae plus the present value of the tax savings from debts, less the present valule of financial distress costs

Question 7

Trade off theory formula

Answer 7

V^L = V^U + PV(interest tax shield) - PV(Financial distress costs)

Question 8

Three key factors determine the present value of financial distress costs

Answer 8

1) the probability of financial distress

2) The magnitude of the costs if the firm is in distress

3) The appropriate discount rate for the distress costs

Question 9

The presence of financial distres scosts can explain why

Answer 9

Firms choose dbet leves that are too low to fully exploit the interest tax shield

Differenceis in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries

Question 10

agency costs

Answer 10

Costs that arise when there are conflicts of interest between stakeholders

Question 11

asset substitution problem

Answer 11

when a firm faces financial distress, shareholders can gain from decisions that increase the risk of the firm sufficiently, even if they have a negative NPV

Question 12

Cashing out

Answer 12

when a firm faces financial distress, shareholders have an incentive to withdraw cash from the firm if possible.

As an example, suppose baxter has equipment it can sell for $25,000 at the beginning of the year. It will need this equipment to continue normal operations during the year; without it, Baxter will have to shut down some operations and the firm will be worth only $800,000 at year-end. Although selling the equipment reduces the value of the firm by $100,000, if it is likely that Baxter will default at yearend, this cost would be borne by the debt holders. So, equity holders gain if Baxter sells the equipment and uses the $25,000 to pay an immediate cash dividend. This incentive to liquidate assets at prices below their actual value to the firm is an extreme form of underinvestment resulting from the debt overhang.

Question 13

Esstimating debt overhang: equity holders will benefit from the new investment only if:

Answer 13

NPV/I > betaDD/betaEE

I = amount invested in a new investment project with similar risk to the rest of the firm

Question 14

Leverage ratchet effect

Answer 14

Once existing debt is in place

1. Shareholders amy have an incentive to increase leverage even if it decreases the value of the firm
2. shareholders will not have an incentive to decrease leverrage by buying back debt, even if it will increase the value of the firm

Question 15

debt covenants

Answer 15

Covenants may limit the firms ability to pay large dividends or restict the types of investments that the firm can make. They also typically limit the amount of new debt the firm can take on. By preventing management from exploiting debt holders, these covenants may help to reduce agency costs.

Question 16

management entrenchment

Answer 16

Facing little threat of being fired and replaced, managers are free to run the firm in their own best interest. As a result managers may make decisions that benefit themselves at investors expense.

Question 17

free cash flow hypothesis

Answer 17

The view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed to make all positive NPV investments and payments to debt holders

Question 18

Agency costs and trade of theory combined formula

Answer 18

V^L = V^U + PV(interest tax shield) - PV(financial distress costs) - PV(agency costs of debt) + PV(agency benefits of debt)

Question 19

credibility principle

Answer 19

Claims in ones self interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue

Question 20

signaling theory of debt

Answer 20

The use of leverage as a way to signal good information to investors

Question 21

lemons principle

Answer 21

When a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to adverse selection

Question 22

adverse selection implications

Answer 22

1. The stock price declines on the announcement of an equity issue (when a firm issues equity, it signals to investors that its equity may be overpriced. As a result, investors are not willling to pay the pre-announcement price for the equity
2. The stock price tends to rise prior to the announcement of an equity issue
3. Firms tend to issue equity when information asymmetries are inimized, such as immediately after earnings announcements (studies have confirmed this timing and reported that the negative stock price reaction is smallest immediately after earnings announcement)

Question 23

pecking order hypothesis

Answer 23

The idea that managers will prefer to use retained earnings first, and will issue new equity only as a last resort