L7: Capital Structure - Tradeoff Theory, Financial Distress Flashcards
What is the idea of tradeoff theory?
The total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs.
What determines the optimal level of debt in tradeoff theory?
Tax benefits vs. distress associated costs
What is financial distress?
A situation where a firm’s operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action.
Note: the current obligation can be other things than the servicing of debt.
Corrective actions include:
- restructuring liabilities with its creditors
- issuing new securities
- selling assets
- bankruptcy.
What is the Absolute Priority Rule (APR) and is it followed in practice?
States that senior claims are satisfied before junior claims.
According to the rule:
- Equity holder get nothing
- Secured creditors get full payout
- Unsecured creditors get whatever is left
In practice:
- Equity holders get something 81% of the time
- Secured creditors get full payout only 92% of the time
- Unsecured creditors get something in 78% of cases in which secured creditors were not fully paid
- (Practice violates APR to some degree depending on the financing regime).
What is tunnelling?
Tunneling is the fraudulent transfer of assets out of the firm for the benefit of those who control it. The incentive to tunnel is magnified when the firm is in distress.
What are common examples of tunnelling?
- Excessive salaries (when manager is also owner)
- Buying goods and services at excessively high prices from another company controlled by the owners
- Sell assets at below-market to another company controlled by the owners
- Give interest-free loans to entities affiliated with owners
How can direct costs of bankruptcy be reduced?
- A workout: the firm successfully renegotiates with the creditors outside of bankruptcy
- A prepackaged bankruptcy: developing a reorganization plan with the main creditors prior to entering bankruptcy proceedings.
What are direct costs of financial distress and what is the typical size of them?
When in financial distress, stakeholders typically hire outside experts (lawyers, consultants, appraisers, accountants, etc) to help with bankruptcy proceedings.
- Average 2-5% of pre-bankruptcy market value of assets for large firms.
- Average 12-25% for small firms.
However, these figures must be weighted by the probability of bankruptcy.
- About 0,1% per year for large firms (e.g. NYSE-AMEX).
Expected direct costs therefore tend to be small
- E(COFD) = probability of distress * cost when in distress
- About 0,02-0,05% of firm value
Is the size of direct financial distress costs the reason we see low debt ratios in reality?
No.
Typical size of tax shield: 10-35 cents per dollar of debt.
- Size of tax shield outweighs direct financial distress costs
→ Direct costs of bankruptcy are too small to account for low debt ratios found in reality.
Indirect financial distress costs can potentially be more important.
- May matter even if the distressed firm is able to avoid bankruptcy
- Indirect costs can be up to 10-20% of firm value.
What are some indirect costs of financial distress?
Difficult to measure accurately, but often much larger than direct costs.
- Loss of customers
- Loss of suppliers
- Loss of employees/talent
- Loss of receivables
- Fire sales of assets
- Inefficient liquidation
- Costs to creditors
What are “loss of customers” indirect costs?
Because bankruptcy may enable or encourage firms to walk away from commitments to their customers, customers may be reluctant to purchase products whose value depends on future support or service from the firm (future operations).
What are “loss of suppliers” indirect costs?
Suppliers may be unwilling to provide a firm with inventory if they fear they will not be paid.
What are “loss of employees/talent” indirect costs?
If you can’t offer job security with long-term employment contracts, it might be difficult to hire new employees, and existing employees may quit or not work as hard. Employees are often incentivised by career advancements within the firm
What are “loss of receivables” indirect costs?
Firms in financial distress tend to have difficulty collecting money that is owed to them.
What is 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. Then, they may accept a lower price than would be optimal if it were financially healthy.
Often deeply discounted selling prices:
- Assets often firm specific, with a limited number of other buyers that could use them
- Some assets (intangibles) may not be possible to sell at all
- Can explain why tech firms often have very low leverage
Especially problematic if sale is urgent:
- Other firms in the same industry may also be constrained (e.g. industry-wide distress)
- May have to sell to a non-industry, financial buyer
- Cyclical industries typically face higher fire-sale costs for this reason (airlines, cars).
–> argument for bankruptcy code that allows reorganization rather than liquidation
- Bankruptcy liquidations typically experience fire-sale discounts of 30-50%.
