Chapter 16 - Financial distress, managerial incentives, information Flashcards
As we know from Modigliani and Miller, capital structure does nto matter in perfect capital markets.
However, in the presence of taxes, we know that there is a tax shield that can be utilized.
Yet, many firms dont use the level of leverage that they “should” from this perspective. Why not?
All of the earlier discussions assume known cash flows. In reality, many industries have far from knonw cash flows.
For instance, airlines are extremely affected by economic events. They risk bankruptcy if they are leveraged too much.
Define financial distress
Financial distress is a term used when a firm struggle to fulfill their financial obligations/debt obligations
What is default
A position that firms are in if they fail to pay their debt obligation
In the case of default, debt holders are given certain assets of the firm.
Discuss the statement a firm need not default as long as the market value of its assets exceeds liabilities
If the firm has access to capital markets and can issue new securities at a fair price, then it needs not to default.
Example: Firm has 100 million in debt. 10 million shares outstanding.
Value of equity is 50 million.
Current share price = 50 / 10 = 5 bucks per share.
To raise the 100 million to pay debt, it can issue 100/5 = 20 million new shares, as long as it is for 5 usd per share.
Now, there is no debt, the equity is worth 150 million, and since there are 30 million shares outstanding, the share price remains unchanged at 5 bucks per share.
The thing is that the ASSETS are worth 150 million, but they represent future profits as well. When the debt obligation of 100 million comes, the firm might not have this cash at hand, and may have to issue shares.
KEY: When issuing shares like this, the only thing that change, is the fact that the firm no longer has the debt obligation. However, the original equity holders still receive the exact same earnings as they would before. The difference is that the 100 million of the 150 million of the assets is now distributed to new equity holders instead of debt holders.
Is default dependent on cash flow?
not necessarily. It is about the relative values of the firms assets and liabilities.
if the project of the firm happen to earn less funds than the debt it used, then the equity is essentially negative, and if so, it is impossible to issue new shares at a fair price
Elaborate on the comparison between unlevered and levered structure in terms of “new product fail”
new product fail means that earnings are lower than expected, and people lose money.
Let us say the expected positive value was 150. It turns out to be 80.
All-equity: 150 - 80 = 70 loss
Leveraged with 100: equity holders loose 50. Debt holders gain the 80, but they invested 100, so they loose 20.
Notice how the loss in total is the same for both cases. 70. The only difference is that one case leads to bankruptcy and the other is a hard hit to the face.
Does the risk of default reduce the value of the firm?
No, if assuming MM1 principle of perfect capital markets.
The value of the firm is dependent on the value of the assets. The capital structure will change where the value is allocated, but we look at it from the perspective of all investors combined. Therefore, it doesnt really matter if debt holders receive more, or if equity holders receive more. It is about the total.
is this realistic? No. Bankruptcy is very complex and is not typically included well in the perfect capital markets structure
What is chapter 7?
Liquidation procedure.
Liquidate assets through an auction.
The proceeds are used to pay the creditors. Afterwards, the firm cease to exist.
What is chapter 11?
Reorganziation.
The firm develop a new plan that specifies the roles of the creditors. The point is that this new plan can give creditors more money than they otherwise would have gotten.
The creditors are typically payed less than originally owed, but still payed more than what they would get from liquidating the firm.
Elaborate on the important aspects of the bankrupcty process
It is costly. Both chapter 7 and chapter 11 cost lots.
Chapter 7 cost on average 12% of the pre-bankruptcy market value of the assets.
Chapter 11 cost on average 4%.
Because of this, it is very common to try to avoid bankruptcy by dealing directly with the creditors before initating the process.
What is a workout
A workout is a successfull reorganization that avoids bankruptcy.
What is a prepack?
Prepackaged bankruptcy. reorganization + chapter 11 to make a nice process.
elaborate on how financial distress can affect the cash flows, even though MM principle say it wont
idirect costs like consumers changing brand, suppliers going somewhere else etc.
Elaborate on a firm all equity vs leveraged in terms of total value of the firm
The leveraged will have to account for financial distress costs, which will lower the total value.
Therefore, a firm 100% financed through equity is likely worth more than the same firm/same assets financed by debt.
Who pays for the finaancial distress costs?
Equity holders. But nto directly, it is sort of indirectly.
Here is what happens: When default, the equity holders dont give a shit anymore. However, the debt holders do. Since they do, they know that if the firm defaults, they will be payed less than they ‘should’. Since they know this, they will pay less for the debt initially.
They will pay less by the amount of expected financial distress costs.
This is something that the equity holders must give up when running the firm, and it represent money out of their pockets.
So the point is that debt holders know and care about the risk of default, because in such scenarios they will be payed less.
