Lesson 11: Other Factors Affecting Optimal Debt-Equity Ratio Flashcards
What is financial distress?
The potential of bankruptcy, lowers the value of a company due to the potential of these additional costs.
What are the two types of bankruptcy?
Chapter 7 liquidation
Chapter 11 reorganization
What happens as a result of a chapter 7 liquidation?
A trustee supervised the liquidation of the assets. The assets are sold at auction and the firm ceases to exist.
What happens as a result of a chapter 11 liquidation?
The company’s management gets 120 days to propose a reorganization plan. This time may be extended. During this time the company continues to run. The creditors vote on this plan. The plan must be approved by bankruptcy court. If no plan is acceptable, chapter 7 liquidation may be forced.
What are the direct costs of bankruptcy?
Fees of the various professionals needed: lawyers, accountants, auctioneers, appraisers. Since many of these costs are fixed, they may be a higher percentage of assets for smaller companies.
What are alternatives to bankruptcy, designed to save the direct costs?
- Workout. The company deals directly with the creditors and works out an agreement.
- Prepackaged bankruptcy also known as a prepack. The company first works out a reorganization plan with the biggest creditors, then filed a chapter 11 reorganization and pressures the remaining creditors to accept it.
What are the indirect costs of bankruptcy?
Loss of customers
Loss of suppliers
Loss of employees
Loss of receivables
Fire sale of assets
Inefficient liquidation
Costs of creditors
What is trade-off theory?
VL = VU + PV(tax shield) - PV(financial distress costs) - PV(agency costs) + PV(agency benefits)
What is the asset substitution problem?
Companies in distress substitute risky assets for non-risky ones.
What is debt-overhang?
Companies do not make positive-NPV investments because only creditors will benefit.
How do you approximate required NPV for equity holders to benefit?
NPV / I > (Bd * D / Be * E)
What is the leverage ratchet effect?
Presence of debt leads to issuing more debt
What are agency benefits of leverage?
Control of company in fewer hands
Management has greater share of equity, discouraging waste
No empire building
Management more likely to be fired in financial distress
Financial distress may lead to wage concessions
More incentive to compete
What is the credibility principle?
Actions speak louder than words, when the words are in self-interest.
What is adverse selection?
Sellers with private information sell the least desirable items.
