Lecture 3 Financial distress costs

Question 1

What two types of financial distressed costs are there?

Answer 1

direct and indirect financial distress costs

Question 2

What are examples of direct financial distress costs?

Answer 2

l- Lawyers
- Accountants
- Restructuring advisors
- Turnaround specialists
- Court-fees

Question 3

on average what are he direct costs of bankruptcy?

Answer 3

3.1% of the book value of debt plus the market value of equity prior to the bankruptcy filing in 29 out of 37 the Absolute priority rule was violated.

Question 4

what is the order of most value recovery? Chatper 11 (restructuring) chapter 7 (liquidation) and distressed exchanges

Answer 4

Distressed exchanges
chapter 11
chapter 7

Question 5

How to calculate the credit spread?

Answer 5

Credit spread = ytm – rf = (E(1+r))/(1-p*LGD)-1-rf
Where r = return rf = risk free rate p = probability of default LGD = loss given default measured as a percentage
* E(1+ri): Expected return on the bond.
* p: Probability of default.
* LGD: Loss Given Default, which represents the percentage of the exposure that is not recoverable in the event of default.
* rf: Risk-free rate.

Question 6

Exercise: calculate the credit spread
Rf = r = 0.03
Moody’s Caa3 PD (Probability of default) = 20.3
LGD = 0.03

Answer 6

(1+0.03)/(1-0.203*0.03)-1-0.03=0.63

Question 7

Why is it hard to compare different bankruptcy procedures using market prices of securities?

Answer 7

• market prices are impacted by economic and financial distress costs
• choice of the bankruptcy resolution is endogenous,
• Statistical correction or clever empirical approach required

Question 8

How to deal with the endogenous choice of bankruptcy procedures

Answer 8

Use heckman two stage procedure

Question 9

When are firms more likely to file for cahpter 11?

Answer 9

Larger firms
firms with financial insolvency but no economic distress

Question 10

when are firms more likely to go for liquidation (chapter 7

Answer 10

fiif a bank occurs as creditor

Question 11

key takeaways direct financial distress costs

Answer 11

• Findings suggest that distressed exchanges are cheapr than chapter 11 who in turn are cheaper than chapter 7
• Sample base is different and results might not be comparable (firms with public debt vs. firms with public equity, railroad or airline companies)
• Bankruptcy resolution procedure is endogenous -> omitted variable bias
• Comparatively little is known about these endogenous dynamics from an empirical side (this is particularly true for European firms)

Question 12

What are examples of indirect financial distress costs

Answer 12

• Loss in customer base
• Higher debt costs
• Worse supplier terms
• Loss of key employees
• Resources bound for restructuring
• Indirect financial distress costs are hard to measure

Question 13

how high are total financial distress costs on average?

Answer 13

10-20 percdent

Question 14

How to calculate financial distressed costs?

Answer 14

Calculate the value of the firm when it is destressed and howmuch it would have been if it would not have been distressed using implied values from the current makret price.

Other study calculates costs:
- Firms does not default: firm value is V
- Frim does default firm value is L
- Net cost of default = V – L
- Problem here Is that V is unobservable.
- Idea! Use market expectations of bankruptcy costs embedded in security prices
Example empirical strategy
Market value of firm (ex-ante) M = V * (1-q) + L * Q
Q = the risk neutral default probability L = value if default V = value if non default

Question 15

M = 100, L = 80 q = 20%
what are the bankruptcy costs?

Answer 15

Step 1 calculate value if not bankrupt 100=V(1-0.2)+800.2
V = 105
bankruptcy costs (c) = 105 – 80 = 25

Question 16

Calculate credit spread
r = rf = 0.03
p = 20.3%
LGD = 20%

Answer 16

1.03/(1-0.203*0.20)-1-0.03=4.36%

Question 17

What are fire-sales?

Answer 17

quick sale of assets at very reduced prices

Question 18

when are fire sales likely to occur?

Answer 18

if other competitors are also distressed (so maybe they will not have anyone to sell too, and they might not have money to buy it for more)

Question 19

When is an asset sold at depressed values:

Answer 19

Assets are very specific
industry is highly concentrated (buyer cna negoitate low prices)
Competitors are liquidity constrained

Question 20

key taekaways indirect finacial distress costs

Answer 20

• Empirical measurement is very challenging
• Empirical evidence suggests that indirect financial distress costs are much higher than direct financial distress costs

Question 21

What are zombie firms?

Answer 21

• Companies unable to generate sufficient profits to cover their debt servicing costs. These firms are tpically kept alive through external support, such as low interest loans, refinancing or government bailouts, rather than through their own business operations.
• Interest coverage ratio < 1 for at least three consecutive years
• Operating for at least 10 years
• Narrow measure:
  o All of the above + tobin’s q lower than the median of their sector in any given year

Question 22

What are causes for zombie firms

Answer 22

• Low interest rates
• Weak bank health
• Zombie firms crowed out other firms (macro economic damage)

Question 23

Key takeaways about financial distress costs:

Answer 23

• Financial environment in US and Europe characterized by low interest rates and strong government support measure might have prevented financial distress costs from materializing
• However, economy wide financial distress risks might still exist in a latent form (e.g., zombie firms, sovereign default risk), which poses great concdern.