Lecture 5 strategic stakeholder incentives

Question 1

What is the purpose of debt covenants?

Answer 1

restrict misbehaviour by stockholders
gives creditors bargaining power

Question 2

What are examples of negative covenants?

Answer 2

o Limits on dividend payments
o No assets can be pledged to other lenders
o Mergers are not allowed
o Selling or leasing assets only allowed after approval of lender
o No additional debt issuance

Question 3

What are examples of positive covenants

Answer 3

o Maintain working capital at minimum level
o Access to period financing statements for lenders

Question 4

What happens to capital expenditure after covenant violations?

Answer 4

decreases

Question 5

Key takeaways about debt covenants

Answer 5

• Covenants are a frequently used tool in debt contracts to limit conflicts of interestbetween stockholders and creditors (creditor control rights)
• Frequently ivlated but not enforced
• Covenants affect corporate investment decisions

Question 6

Why do we care about finnacial distress costs?

Answer 6

• Bankruptcy itself is not problematic, financial distress costs are
• Ex-post view:
  o Bargaining setup highlights the benefit of financial distress costs for equity holders
  o Debt covenants and CDS limit the bargaining power of shareholders
• Ex ante view
  o Financial distress costs increase cost of capital for a firm (equity holders and creditors anticipate financial distress costs and the bargaining situation at default
  o Trade-off theory of capital structure

Question 7

What is the trade-off theory of capital structure 9Modigliani-iller)

Answer 7

• Firms choose capital structure to optimize the trade-off between tax shield and financial distress costs (VL = VU + PV(tax shield) – PV(fin distressed costs)
  o VL = value levered
  VU = value unlevered

Question 8

Stylized example
- One period model (firm Is alive for one year)
- Firm with a (unsecured) zero bond with a repayment of 1000 at the end of the year
- If the asset value of the firm drops below 1000 the firm cannot reapy the creditors and files for default causing 200 in bankruptcy costs
draw the payoff structure for the creditors

Answer 8

The payoff starts at asset value of 200 and goes up till asset value of 1000 were it hits 800 and goes straight up to 1000 and continues to go up this is since under 1000 the payoff will be -200 due to distress costs

Question 9

What is the payoff structure for stockhoders and credit holders

Answer 9

flat till 1000 afer which it goes up like a call option. credit holders goes up till 1000 fater which it flattens out, like a short put option and a risk free bond

Question 10

What is the difference between the Merton model and the black scholed model?

Answer 10

Merton model is almost the same but the underlying is the firm value rather than the stock value

Question 11

What does the Merton model help us to understand

Answer 11

we can understand equity as a call option on the firm value and debt as a combination of risk-free investment and a put-short position on the firm value

Question 12

what are things that can be explained using the merton mode?

Answer 12

o Risk shifting
o Bail and switch
 Start with lsafe/small amount of debt issuance
 Increase leverage greatly
 Old bondholders suffer loss in market value
o Underinvestment problem: firm does not undertake positive NPV projects
o Cash-in-and-run: create huge payout to shareholders before default

Question 13

• Assume a firm that is currently under financial distress
• The discount rate is 0
• The firm has issued debt of 50 that needs to be repaid in one year
• Assume two states of the world in our binominal tree model, in the bad state the firm will be worth 40 in the good state they will be worth 100, currently the firm is worth 70 with 45 debt and 25 equity

the firm has a project which will either pay 16 or 0 and costs 10, what is the NPV and will the firm invest in this, what is this phenomenon called?

Answer 13

The NPV is (16 + 0 - 20) /2 = -2

in the bad state the total value was 40 with debt of 50 so the stockholders get nothing, now the value will be 30 due to the -10 npv therefor the debtors will only get 30 and the equity does not chnage
in the good state the payoff would be 100 total of which 50 for the debt holders, now it will be 106 so the npv of the equity holders goes up from 25 to 28, thereby they will do the negative NPV investment

this is called risk shifting

Question 14

• Assume that th firm can do a project that pays out 8 in both states of the world in the future
• The costs of doing the project are 5 and the project must be funded by issuing additional equity today
• What is the NPV?

will the firm invest?
what is this phenomena called

Answer 14

NPV = 3 in both states costs = 5

in the bad state the 8 extra income will all go to the debt holders, in the good state the 8 extra income will go to the stock holders this is a npv increase for the stockholders of 4 but with a cost of 5 this is a negative NPV for them thereby not investing in a profitable investment
this is called underinvestment problem

Question 15

what are the consequences of agency costs?

Answer 15

• Lender anticipate agency problems
• May refuse to lend money in the first place (profitable investments are also not possible
• Debt covenants are frequently used to limit the rights of management and to protect creditors, but
  o Negotiaitno of contracts and control is costly
  o May prevent profitable (risky) projects

Question 16

Key takeaways

Answer 16

• Financial distress costs impact the market value of the firm
• Ex-ante: shareholders and creditors price (anticipate) financial distress costs and the situation at default
• Understanding equity as a call option on the firm value (merton model) provides a conceptual understanding of stakeholder incentives