Chapter 16 - Financial distress, managerial incentives and information Flashcards
Recall the general insights from chapter 15, of debt and taxes
The outcome of that chapter was that when taxes are involved, we do not have perfect capital markets, and the capital structure actually do matter.
It turns out that there is a benefit in using debt, as there is an interest tax shield that can be leveraged to keep a larger portion of the cash inside of the firms investors pockets, rather than governements.
However, regardless of this fact, the capital structure of firms vary a lot. This is established empirically, and when looking at it from the perspective of tax shield, it does not make a lot of sense.
The sensemaking arrives when we look at what the additional debt actually does to a firm.
Firstly, increasing debt means that the required return increase. But with an increase in required return, we know from CAPM that this must be the result of increased risk. This risk increase is of course related to the fact that for equity holders, introducing debt will amplify the returns relative to the amount of equity they hold. This amplification goes both ways, positive and negative, but the epxected returns grow higher than before.
So why should this be bad, we know that the expected return grows higher with debt?
The reason why this ‘can’ be bad, is that the additional risk increase the probability of default. for certain industries, especially the ones that are more exposed to swings in the overall economy (large beta) can be majorly fucked if they leverage too much, as they stand the risk of loosing the entire business.
Because of this effect of risk, we need to find a way to account for this, so that we can be more precise in our computations of a firm’s cost of capital.
Give the short version of why optimziing for the itnerest tax shield alone is not sufficient?
we need to include the elemetn of financial distress. Financial distress is the term we use to describe a situiatoin where a firm STRUGGLE to pay its debts.
If a firm struggle to pay its debt, the capital structure can suddenly be detrimental to the survival of the firm.
What does debt financing “do”?
Debt finanacing puts an obligation to the firm. This obligation is crucial to understand, because if not handled properly, the firm is fuckedf.
Default vs bankruptcy..?
Default is a stage, or something that just “happens”. it specifically refers to a firm that fails to pay debt.
Bankruptcy is a process that is legal process, and have parties involved and is more formal.
Default is just an event that describes a firm not paying debt. It can be a strong signal of finanacial distress, but it does not necessarily involve a bankruptcy process.
debt financing has an obligation to pay creditors. how about equity?
NOpe. Equity holders will hope to receive dividends, but there is no obligation from the firm to do so. therefore, we say that equity financing is less risky in this way.
if a firm dont receive the cash flow they hoped, and does not have the cash flow to pay debt, will it default?
Not necessarily. As long as the assets value exceed the liabilities, they can raise new capital, either through issuing more shares or through new loans.
Does default depend on cash flow?
no. Default depends on the underlying value of theunderlying assets VS the liabilities. As long as the value of the underlying assets exceed the liabilities, then the firm will be able to raise funds.
Many firms experience many consecutive years with negative cash flow, yet are able to not default.
Why are we so interested in the total value of the firm, rather than equity value+
The total value of the firm represent how much money the firm can raise.
What can we say about the happiness of investors if the project fails and it has all equity vs fully debt leveraged?
The investors will be equally unhappy in either case.
This is because the underlying assets determine the ultimate value of the firm. If these assets decrease in value, then the effect is the same for the investors. Recall that ivnestors refer to both equity and debt holders.
In perfect capital markets, is the risk of bankruptcy a disadvantage of debt?
no. Bankruptcy just shifts the ownership of the firm from equity holders to debt holders. So in perfect capital markets, this would not do anything about the value of hte firm. The losses would be the same in total.
however, since there are usually many costs involved, doing a bankruptcy process is costly and will have an impact which is a disadvantage of debt.
If a firm defaults on a loan, what can happen?
Debt holders can start the legal process. They essentially want to acquire the assets of the firm.
This is difficult though, because the assets of the firms cannot typically be easily split among the many differnet debt holders.
What is the US bankruptcy code?
A process created to have a structured and fair process when firms are defaulting etc.
Firms can file for types of bankrupcty protection?
2 types: chapter 7 and chapter 11.
elaborate on chapter 7
chapter 7 refers to chapter 7 bankriptcy protection. It is commonly referred to as “liquidation” or “chapter 7 liquidation”.
A trustee is appointed that will oversee the liquidation of the firms assets through an auction. The proceeds from the auction is then split on the creditors.
elaborate on chapter 11
usually called chapter 11 reorganization. Common for larger corps.
The firms existing managementmust create a new plan that will “save” the firm. While developing the plan, the firm continue to manage itsdaily operations. All pending collection attempts are suspended.
The new plan specify the role of each creditor. Typically, such a plan involve them getting some equity.
The creidtors must vote on the plan.
elaborate on direct costs of bankruptcy
the process sucks, and reuiqres extreme amount of third party expertise through investment bankers, and much more.
What can be done to save some costs in terms of bankruptcy
try to do a “workout”, which involve dealing with the creditors directly before bankruptcy stage occurs. A financially distressed firm can do this and save tremendous money on both sides of the transactions, so it is typicallymutually benefiical to achieve a workout.
What is a prepack?
Prepackaged bankruptcy. Involves dealing directly with main creidtors to create a reorganization plan, and then after this is ok, file for chapter 11 reorganization with this proposed plan. this can pressure out other smaller creditors, and can save money on the process.
elaborate on indirect costs of financial distress
These are costs that are not directly related to the bankruptcy etc.
We have loss of customers, loss of suppliers, loss of employees, loss of receivables,
why are the losses of debt holder whose claims are not fully repaid not a cost of financial distress, wheras the loss of customers who fear the firm will stop honoring warranties is?
Losses are not a cost of financial distess, but is rather a cost of bad operations.
Loss of customers happen because the firm is struggling ,and is therefore an effect of the firm being in financial distress.
there is a different causaility here.
Modigliani and Miller said that the cash flows of a firm’s assets does not depend on the capital structure. However, when introducing finanacial distress costs, is this still true?
No. The costs incurred as a result of financial distress limit the cash flows to investors, regrdless of whether they hold equity or debt.
do equity holders care about bankruptcy costs?
When they are in the bankruptcy procedure, they dont give a fuck if they have already lost everything.
However, the question is: who is actually paying for these financial distress costs?
Elaborate on who pays for financial distress costs
Debt holders KNOW that if the firm defaults, the bankruptcy costs are lost and gone. Therefore, they will price this in.
In fact, they will reduce their value by exactly the amount that they would loose from financial distress costs.
So what is the outcome of this?
If debt holders are not willing to pay as much for the debt due to these costs, it will basically limit the amount of capital the firm can raise. This means: less funds to pay dividends, less funds to fund projects, repurchase shares etc.
Therefore, it is the sahreholders that actually pay for the financial distress costs.
It leads to the following concluison: “When securities are farily priced, the original shareholders of the equity pay the present value of the financial distress costs”
how do we go about to solve the problem of how much debt a firm should take on, when we have shit like financial distress costs and taxes?
We must use the so-called tradeoff theory
