Financial distress

Question 1

What happens if a firm defaults?

Answer 1

Debt holders are given the right to the assets of the firm.

Equity financing obviously doesnt have this risk. However, because using debt adds a risk of loosing assets, it is sometyhing that must be accounted for.

Question 2

Will a firm be forced to default if it doesnt have enough cash?

Answer 2

not necessarily. If it has more assets than liabilities, it can raise funds through equity.

Question 3

What is the important outcome of the fact that a firm with more assets than liabilities doesnt need to default?

Answer 3

A firm can survive many years of negative cash flow because it can keep issuing equity that is based on the future expectation of the firm’s profits.

Question 4

In regards to both equity holders and debt holders, what can we say about their “feeling” on default?

Answer 4

Both is bad, because both parties loose money.

Question 5

What can we say about the total loss in a default case, where we compare all equity financed vs debt equity mix?

Answer 5

The total loss is the same in both scenarios. The only difference is who takes the larger hit.

If the project is all equity, the equity holders take a major hit if shit goes down.
If debt mix, more of the loss is placed on debt holders.

Question 6

elaborate on economic distress and financial distress

Answer 6

economic distress is defined as a significant reduction in a firm’s assets’ value. Happens regardless of capital structure if the “new product” is shit.

Financial distress is due to leverage. Financial distress is trouble to pay debt as a result of shit product AND having debt obligations.

Question 7

What is the outcome of the MM1 principle in regards to financial distress

Answer 7

Investors as a group are not better or worse off in various capital structures. The total value for investors is the same regardless (in perfect capital markets).

because of this, bankruptcy in perfect capital markets does not hold any cost. It simply shift the ownership of the assets from one party to another. the value lost is due to the economic distress.

Question 8

Does the risk of default reduce the value of the firm?

Answer 8

Not in perfect capital markets. In theory, bankruptcy is a shift in ownership. Therefore, bankruptcy does not equal dissolving of the firm.

However, we know that with bankruptcy in real life, there are major costs involved. For instance, the value of a struggling brand is significantly reduced in many cases, and the legal procedures can cost extreme amounts.

Question 9

There are 2 important considerations we need to make when delving into financial distress costs. Elaborate

Answer 9

1) We must NOT look into what individual investors loose. This is not interesting. we care about the total value of the firm, and need to consider all aspects of it.

2) There are many sources to financial distress costs. However, we must separate those that are a result of the financial distress, and those that are results from economic distress. Economic distress costs is not related to default, and represent a risk of operation, and should be baked into the equity cost of capital.

Question 10

In simple terms, if a firm make cash flow present value perpetuity of 80 million if a product is shit, and has debt obligations of 100 million, what is given to creditors?

Answer 10

In perfect capital markets: 80 million.

In reality, less than 80 million. The difference between what the creditors receive, and the asset value of the firm, is the financial distress cost.

Question 11

elaborate on how we compute the value of the debt from the perspective of the debt holders

Answer 11

They take the expected value of the debt given the success scneario where they receive what they were promised vs the fuck up scenario where they receive assets value less the financial distress costs.

Looks sort of like this:

(100 million/1.05) x 0.5 + ((80 - finDisCost)/1.05)x0.5 = value of debt

Question 12

elaborate on who pays for debt, and the whole nightmare surrounding it

Answer 12

If a firm defaults and go bankrupt, the shareholders are out of the scenery. in other words, they dont give a fuck about the firms value. Therefore, the financial distress costs are not payed by them at this stage.

However, the debt holders know this. In the event of bankruptcy, the debt is worth less than what it should be. Because of this, no one would compute value of debt (before buying it) without the financial distress costs. As a result, the debt become more expensive.

Ultimately, this leads to a relationship between funding a certain set of assets, and a value that doesnt match. For instance, if the assets produce 150 million if successful, and a firm is interested in funding 50% of it with debt, the debt holders would think “if the firm fucks up, how much of these 50% of the assets remains for me”. If they believe a fuckup would result in 50 million value, but after the bankruptcy procedure, they would be worth 25 million, we have a case. 25 m x 0.5 + 75mx 0.5 = 50 million. So, the debt holders would pay 50 million for the funding of those assets.

From this, we can find the debt cost of capital: Price = FC/(1+ytm)^n
ytm = (FC/Price)^(1/n) - 1

ytm = (75/50)^(1) - 1 = 1.5-1 = 0.5 = 50%

From this formula, we can see that if the price increase, the debt cost of capital will be reduced. Or specifrically, the ratio between the Face Value and the Price. This ratio is equal to the ratio between promised payment and the expected payment.

What does all of this mean?

In order to fund 75 million, it must take on debt equal to 75*1.5 = 112.5 million

the major implication of this is that there is now less value in the equity.

The equity was originally worth 150 in success, 80 in rough.
let us say it is equal to 150 regardless.
Since debt holders require a significant premium for the debt returns, they will pay less than face value. Since the firm needs to take on 112.5 million in debt to fund 75 million assets, this is a difference of 37.5 million.
This difference is directly taken from the market value of the equity.

EV = E + D
E = EV - D
E = 150 - 112.5
E = 37.5

Compared to the case with no financial distress, where we’d have E=75, this means that the shareholders now just simply have less value that they can distribute to shareholders, use to raise more funds, etc.

Question 13

What can we say about beta of firms and the financial distress costs of firms?

Answer 13

High beta firms are more likely to struggle significantly during economic downturns. this means that the magnitude of the costs are more likely large. As a result, we can expect their financial distress costs to be larger for high beta firms.

Question 14

how do we know how much equity the creidtors would require if a firm that defaults were to issue equity to pay what they are owned?

Answer 14

we need to consider the options of the creditor. He can choose to not take equity, and recieve the ass

Question 15

elaborate on the tradeoff theory

Answer 15

Weighing the benefits of debt in the shape of the interest tax shield, against the disadvantage of the financial distress costs.

Recall that without debt, there is no financial distress cost.

Also recall how the risk of leverage is not associated with financial distress costs. Financial distress costs is purely from the risk of not beign able to meet debt obligations.

Question 16

give the tradeoff theory equaiton

Answer 16

Levered value of the firm = Unlevered value + interest tax shield - financial distress cost

Of course, present value on all of them

Question 17

First outcome of the tradeoff theory?

Answer 17

Leverage has costs as well as benefits. Firms do have an incentive to incresae leverage bevause of the tax shield, but there is also the increasing cost of financial distress in doing sol

Question 18

What determine financial distress?

Answer 18

We say 3 things influence financial distress:
1) Probability of reaching financial distress
2) Magnitude of the costs, should it hit
3) The discount rate used for financial distress costs to find the present value

Question 19

In general, what influence the probability of reaching financial distress?

Answer 19

Firms with lots of liabilities, volatile tendencies, have larger probability of financial distress becayse the cash flows (unlevered) are so uncertain. More uncertainty means that there is a alrger likelihood of defaulting on the debt obligations.

this means that firms with volatile cash flows simply cannot have that much leverage.

Question 20

What determines the magnitude of the financial distress costs?

Answer 20

Very dependent on the industry.

Also, things like human capital is extremely difficult ot maintain. If default, the firm loose this shit and the debt holders incur heavy losses.

However, if the assets are shit like real estate and liquid tangible assets, these costs are smaller.

Question 21

elaborate on the beta of financial distress costs

Answer 21

the financial distress costs is large when the firm goes down. Therefore, its sign is flipped in relative to the beta of the firm.

Question 22

without financial distress costs, what would leverage be

Answer 22

firms would exhaust the leverage.

Question 23

elaborate on the typical firm’s agency costs

Answer 23

Typicla is shareholders vs debt holders.

The agency costs here are largest in periods of financial distress, where the shareholders get the opportunity to take risk free hail Mary’s at the expense of debt holders risk.

Question 24

what is the main agency cost problem?

Answer 24

when placed in a position where the shareholders basically can get nothing with certainty (a sinking ship) vs say 10% chance of hitting big, they might as well go for it. The expected value is probably negative, which is why this is a real issue. The case is that the debt holders pay all the risk, as the shareholders have nothing to loose.

Question 25

What do we call the scenario where shareholders can gain from increasing the risk of the firm sufficiently, even if the project has negative NPV?=

Answer 25

The asset substitution problem.

Change the assets with more risky assets in a hail Mary-.

Question 26

Define the “debt overhang” or “under-investment problem”

Answer 26

Debt overhang refers to the case where the shareholders of the firm have to possibility of taking on a project that is positive NPV, but will not because it will loose them money.

This situation arise as a result of the debt that needs to be repayed takes a portion of the profit of the project that makes the project undiserable.
There is another requirement for the debt overhang/under-investment problem: The firm must raise equity to fund it. This is what makes it a problem. The firm can raise equity to fund the project, and it will cause positive NPV for the FIRM. But people wont, because it is negative return on equity. You’d just satisfy the debt holders.

Question 27

Define an agency cost problem that is not hte asset substitution or the debt overhang/under-investment problem

Answer 27

Cashing out. If shareholders suspect the ship is sinking, they might consider cashing out some assets and paying dividends immediately.

Question 28

regarding the debt overhang problem:

Recall its other name

Also, when will shareholders benefit from an investment in the presence of a debt overhang?

Answer 28

Under-investment problem.

The shareholders benefit IF:

NPV/I > (debtBeta x debt)/(equityBeta x equity)

So, the ratio of the net present value of the project divided by the investment value, must be larger than the debt equity ratio multiplied by the debt beta debt equity ratio

Question 29

The formula for debt overhang, and when it is beneficial for shareholders to invest, recall that formula. What happens if there is no debt?

Answer 29

NPV/I > (debtBeta x debt)/(equityBeta x equity)

if no debt, it is always beneficial as long as the NPV is greater than 0

Question 30

who bears the costs of agency costs?

Answer 30

It is the same as with the financial distress costs. Debt holders will pay less for the debt. This ultimately lower the value of the equity in the firm, which means that the shareholders take the hit.

Question 31

Elaborate on the leverage ratchet effect

Answer 31

Once existing debt is in place, shareholders may have an incentive to increase leverage even if it decrease the value of the firm, and shareholders will not have an incentive to buy back debt even if it will increase the value of the firm.

Why?

If the firm takes on a lot of debt, it effectively ties up much of its FCF to paying the creditors. This makes it difficult to retain and use cash to change the capital structure to one with less debt. Difficulties in meeting debt obligations can lead to more leverage. And as the firm takes on more leverage, the equity becomes more risky and the debt becomes more expensive as well. Leads to a trap.

Question 32

What is a debt covenant?

Answer 32

Debt covenants refer to restrictions that creditors may enforce as a consequence of receiving the debt. They can have costs of their own because they limit flexibility of the firm, but they also reduce the probability of extreme agency costs.

Question 33

why not issue equity to pay the debt/reduce leverage whenever the firm is struggling?

Answer 33

Lowering the leverage by issuing equity would raise the total value of the firm. However, it will not benefit the shareholders.

Question 34

elaborate on concentration of ownership

Answer 34

Using debt allows the owner to maintain his stake in the firm. If he needed to raise equity, his ownership would be diluted.

With more owners (issuing equity) there is a larger probability of overspending on shit like corporate perks.

However, the cost of reduced effort is porbably the most important. If A dude has 100% of the ownership, he is likely ot give more effort than if he has 10%.

Question 35

elaborate on empire building

Answer 35

Empire building is an agency cost related to the manager/CEO of the firm vs shareholders. Like always, shareholders want value.
However, CEO’s may actually value size more. Thus, they might make deicisons based on scope rather than value. We are talking acquisitions, capital expenditure, establishing multiple divisions, hire a shit load of employees.

Question 36

Elaborate on the free cash flow hypothesis

Answer 36

Building up cash reserves is more likely to lead to fucked up spending. Better to pay it.

When cash is tight, people make the best decisions.

Question 37

What is the credibility principle?

Answer 37

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

Question 38

What is signaling theory of debt?

Answer 38

Taking on debt as a confidence boost. For instance, if CEO owns much of the stokc himself, and he takes on much debt, he is likely confident that the firm will make cash. Therefore, the debt is a signal to investors that he is confident, which cna provide credibility.

Question 39

What is adverse selection?

Answer 39

Adverse selection is the state where sellers take advantage of market asymmetric information and try to get a good deal.

Leads to the lemons principle: If the seller has more information than the buyer, the buyer will only buy at discounted price as a result of adverse selection.

Question 40

How does the lemons principle relate to stocks?

Answer 40

Say the owner of a firm wants to sell a stake of his. He claims it is good, but since we know that he has more information than us, we should not trust what he says and only buy at discount.

Question 41

elaborate on adverse selection and issuance of stock

Answer 41

Because of asymmetric information, if a firm announce that they will issue equity, the price is likely to drop.

However, what typically happens before the announcement? The firm will issue at a very beneficial stage. Therefore, they will not delay issuance if they expect negative news to come out. Therefore, the stock tend to do very well in the period before the equity issuance.

Question 42

when can a firm issue equity in a way that minimize the aymmetric information?

Answer 42

Immediately after earnings.

Question 43

Elaborate on the pecking order hypothesis/theory

Answer 43

Firms will only issue equity as a last resort.

it is backed by the fact that managers who find the share price underpriced will not issue equity, and instead use retained earnings or debt to fund projects. At the same time, if the equity is overpriced, the drop in equity as a result of the issuence is typically large enough to make managers try to locate other options first. This leads to the scenario where many believe that issuing equity is a last resort.

it appears that the preference is to use retained earnings. Firms are also more net repurchasers rather than issuers.

Question 44

In the later part of this chapter, we relax the assumption of everyone knows the same. What implications does this have on capital structure?

Answer 44

It can be more of a timing thing than others.

Market timing view refers to how a firm’s structure emerge as a result of the conditions that existed in the market at the time when they made the structure. Therefore, firms within the same industry can end up having differnet structures while being optimal for each.