Chapter 16 - Financial distress, managerial incentives and information

Question 1

Recall the general insights from chapter 15, of debt and taxes

Answer 1

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.

Question 2

Give the short version of why optimziing for the itnerest tax shield alone is not sufficient?

Answer 2

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.

Question 3

What does debt financing “do”?

Answer 3

Debt finanacing puts an obligation to the firm. This obligation is crucial to understand, because if not handled properly, the firm is fuckedf.

Question 4

Default vs bankruptcy..?

Answer 4

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.

Question 5

debt financing has an obligation to pay creditors. how about equity?

Answer 5

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.

Question 6

if a firm dont receive the cash flow they hoped, and does not have the cash flow to pay debt, will it default?

Answer 6

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.

Question 7

Does default depend on cash flow?

Answer 7

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.

Question 8

Why are we so interested in the total value of the firm, rather than equity value+

Answer 8

The total value of the firm represent how much money the firm can raise.

Question 9

What can we say about the happiness of investors if the project fails and it has all equity vs fully debt leveraged?

Answer 9

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.

Question 10

In perfect capital markets, is the risk of bankruptcy a disadvantage of debt?

Answer 10

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.

Question 11

If a firm defaults on a loan, what can happen?

Answer 11

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.

Question 12

What is the US bankruptcy code?

Answer 12

A process created to have a structured and fair process when firms are defaulting etc.

Question 13

Firms can file for types of bankrupcty protection?

Answer 13

2 types: chapter 7 and chapter 11.

Question 14

elaborate on chapter 7

Answer 14

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.

Question 15

elaborate on chapter 11

Answer 15

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.

Question 16

elaborate on direct costs of bankruptcy

Answer 16

the process sucks, and reuiqres extreme amount of third party expertise through investment bankers, and much more.

Question 17

What can be done to save some costs in terms of bankruptcy

Answer 17

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.

Question 18

What is a prepack?

Answer 18

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.

Question 19

elaborate on indirect costs of financial distress

Answer 19

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,

Question 20

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?

Answer 20

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.

Question 21

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?

Answer 21

No. The costs incurred as a result of financial distress limit the cash flows to investors, regrdless of whether they hold equity or debt.

Question 22

do equity holders care about bankruptcy costs?

Answer 22

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?

Question 23

Elaborate on who pays for financial distress costs

Answer 23

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”

Question 24

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?

Answer 24

We must use the so-called tradeoff theory

Question 25

short description of the tradeoff theory

Answer 25

Weighs the benefits of interest tax sheild vs the added disadvantages of the additional financial distress costs.

Remember that financial distress costs are only present with leverage.

Question 26

elaborate more deeply on the tradeoff theory

Answer 26

According to this theory, the total value of the firm should be like this:

V(levered) = value(unlevered) + PV(interest tax shield) - PV(financial distress costs)

Question 27

How do we determine the financial distress costs+

Answer 27

Very complicated problem, but generally we say that there are 3 influencers of it:

1) Probability of financial distress
2) Magnitude of costs if the firm is in distress
3) Appropriate discount rate

Regarding the probability of financial distress, this is determined sort of by the volatility of the cash flows and the size of the debt. Large firms with steady incomes and low betas will have a low probability of default, while the opposite applies to firms that perhaps has a larger beta and a larger debt portion of its capital structure.

In regards to the magnitude of the financial distress costs, this is very dependent on the industry. In certain industries, the assets are easily liquidable etc, which can make these costs easier to manage. In other industries, for instance in niches, it may be extremely difficult to find value of the assets, which can create large financial distress costs.

Question 28

What can we say about the beta offinancial distress costs?

Answer 28

Will be negative in relation to the beta of the firm, because if the firm does shit

Question 29

According to the tradeoff theory, what should a firm do?

Answer 29

Seek the point where we have received as much benefit from the interest tax shield as possible, and adding more debt will not be beneficial because the added debt increase the financial distress costs (through probability and magnitude) which makes the overall levered value of the firm decline.

Question 30

what is the relationship between leverage and industries according to the treadeoff theory

Answer 30

If you are in an industry that has more volatile cash flows, more debt is likly not a good option as compared to industries that have low volatility returns.

Question 31

Name a typical case of agency cost

Answer 31

The battle between shareholders and debt holders. Especially if the likelihood of financial distress is large, managers and owner of the equity tend to make deicisons that is most favorable for the equity, as this will make them more cash.

Question 32

Why can shareholders try something risky in the event of financial distress?

Answer 32

from the perspective of shareholders, if they fuck up, they loose everything. Therefore, if they can locate a hail mary to gain cash, but at the expense of fucking up creditors, they will likely do it because it is in their best interest.

The case really is that if you are presented with 2 options, where option 1 is certain default, and the other is a hail mary, you might as well go out guns blazing.

Question 33

what is the asset substitution problem?

Answer 33

The asset substitution problem is the case where a firm is leveraged, and this leverage cause the equity holders to replace assets with more risky assets, as this can increase the expected value of equity, even though the overall project has negative NPV.

Question 34

what can we say about the asset substitution problem in regards to when it is more severe?

Answer 34

it the firm or industry is particularily known for easily risk adjusted measures, then this is somthing to be concerned about

Question 35

During financial distress, what is a problem related to agency costs that is not the asset substitution problem+

Answer 35

We call is debt overhang or under-investment problem.

it refers to cases where the managers of the firm (who are equity holders) choose to not select NPV positive projects because it would lower the equity but increase debt value by more than it lowers equity. For the equity holder, this sucks, and they would never do it. However, when considering a corp finance view, it would be beneficial for the firm as a whole.

Question 36

What is the “extreme” stage of the under-investment problem (debt overhang)?

Answer 36

When shareholders start selling assets in order to cash out money. This will basically reduce the value of the firm, and reduce the cash flow the debt holders will receive in a chapter 7

Question 37

when will equity holders benefit from a new project

Answer 37

Question 38

Who pays for the debt overhang problems and asset subsitution problem?

Answer 38

According to the book, it is the equity holders. It is because the debt holders “recognize” the possibility of this, and therefore pay less for the debt.

Question 39

What is the leverage ratchet effect?

Answer 39

Once existing debt is in place, shareholders might benefit from
1) increase leverage even though it decrease the value of the firm
2) shareholders will not have an incentive to decrease leverage by buying back debt, even if it will increase the value of the firm.