Section 12

Question 1

what is bankruptcy caused by?

Answer 1

insufficient cash flow to meet obligations. size of firms cash flow may depend on things outside of the firms control, like macroeconomic conditions, but firm choose amount of debt in capital strucutre and investment projects - which are under their control

Question 2

if bankruptcy is viewed as exogenous, how does the procedure play out in relation to management?

Answer 2

will leave management in place and, may even protect management

Question 3

if bankruptcy is viewed as the result of managers actions, how does the procedure treat them?

Answer 3

tend to remove incumbent equity holders and management

Question 4

why is bankruptcy code important?

Answer 4

legal procedure determines relative bargaining power of various claimants to firm; important for security pricing and design because they affect security value (different rules and procedures affect how much firm value is allocated to different security classes)

Question 5

why does debt exist?

Answer 5

serves to control the equity holders/managements. if they perform badly, it loses control to creditors. how and when this happens depends on bankruptcy procedure. bankruptcy code should be more creditor-oriented procredure

Question 6

optimal bankruptcy rules preserve..?

Answer 6

going-concern value, but don’t entrench managers or equity holders. provide balance between exogenous and endogenous factors

Question 7

if the bankruptcy rules aren’t designed well, what can happen?

Answer 7

one party or another can take advatnage of rules strategically to transfer value to themselves at the expense of others (Strategic bankruptcy filing)

Question 8

in the mid 1970’s the US Congress passed?

Answer 8

Bankruptcy Reform Act of 1978

Question 9

What did the Bankruptcy Reform Act of 1978 do?

Answer 9

easier for managers to invoke bankruptcy protection. Doesn’t require debtor actually be insolvent in order to file protection from creditors.

Question 10

Passage of the 1978 act led to what?

Answer 10

large increase in voluntary bankruptcy filings. Before filing, ten filings per day. after the first year it was passed, 16 per day. increase wasn’t explainable by economic circumstances

Question 11

prior to the act what was the relationship between filings and economic activity?

Answer 11

more filings were associated with recessions

Question 12

after the act of 1978 what happened to the historical relationship?

Answer 12

no such association. act benefited a specific group by creating strategic option for one group

Question 13

in the pre-1978 act era vs post, describe impacts to stockholders?

Answer 13

in pre-act era, stockholders lost more than 50 cents per dollar, but in post act period, they lost almost everything (per dollar); average dollar loss is almost 3x greater after the fact; about $14Bn more was lost after the act for roughl the same number of firms

Question 14

if Bond and stockholders losses were greater after the passage of the act, why did number of filings increase?

Answer 14

managers may have benefited. survival rate of firms went from 74% to 84%

Question 15

the transfer of control from equity holders to bond holders that is supposed to occur when a firm becomes insolvent is governed by?

Answer 15

bankruptcy procedures. they regulate the transfer, but create strategic possibilities for various parties including managers

Question 16

The firm is viewed as a nexus of contracts between?

Answer 16

economic players

Question 17

what are the three types of economic players?

Answer 17

manager, equity holder, and debt holder

Question 18

In the agency literature, who’s the manager?

Answer 18

the agent

Question 19

in the agency literature, who’s the investors (equity and debt)?

Answer 19

principal

Question 20

from a legal perspective, shareholders are or are not owners of the firm?

Answer 20

are owners

Question 21

from a legal perspective, mangers may also be owners of firm?

Answer 21

may also be partial owners when they own stock in the firm

Question 22

what’s the key assumption in the agency literature regarding each agents and their payoff?

Answer 22

each agent only maximizes their own payoff

Question 23

should a firm never invest in a project with a negative beta?

Answer 23

no - a project with negative beta (has higher return than the CAPM return of a same beta portfolio) should be considered.

Question 24

why are assets with negative beta valuable?

Answer 24

they reduce portfolio variance

Question 25

In the presence of agency conflict, who dominates debt between creditors and equity holders?

Answer 25

equity

Question 26

when the entrepreneur sells equity, he bears the full cost of effort but only receives…?

Answer 26

a fraction of the output

Question 27

The more outside equity, the more severe is the..?

Answer 27

inefficient production problem, thus the lower value of the firm

Question 28

what can solve the underproduction problem partially?

Answer 28

debt finance

Question 29

describe chapter 7 liquidation

Answer 29

trustee is appointed to oversee the liquidation of the firms assets through an auction. proceeds are used to pay firms creditors and firm ceases to exist

Question 30

describe chapter 11 reorganization

Answer 30

firm files for bankruptcy protection and all pending collection attempts are automatically suspended in (AUTOMATIC STAY). management continues operations and is given 120 days to propose reorganization plan, specifying treatment of each creditor of firm.

Question 31

what are direct costs of bankruptcy?

Answer 31

out of pocket costs associated with defaulting on obligations in debts, and going through court supervised bankruptcy process. things like court, lawyer, accountant, and investment banking fees. studies show roughly 3%-4% of asset values in costs

Question 32

what are indirect costs of bankruptcy?

Answer 32

loss of customers that value post sale services, loss of willing suppliers, difficulty retaining and recruiting employees, forced sales of assets and reduced prices. sometimes can almost 20% of firm value (Estimate)

Question 33

what are agency costs?

Answer 33

losses in value associated with having an agent with different interests work on behalf of the principals, or owners.

Question 34

of all the different imperfections that drive capital structure, the most significant is likely to be..?

Answer 34

taxes: interest tax shield allows firms to repay investors and avoid corporate tax

Question 35

firms must balance the tax benefits of debt with..?

Answer 35

costs of financial distress

Question 36

agency costs and benefits of leverage are also important determinants of…? and why..?

Answer 36

capital structure. too much debt can motivate managers and equity holders to take excessive risks or underinvest in a firm. when free cash flows are high, too little leverage may encourage wasteful spending

Question 37

define default

Answer 37

when firm fails to make required interest or principal payments on debt

Question 38

define bankruptcy

Answer 38

court supervised reorganization of firms financial claims governed by 1978 reform act

Question 39

define trade-off theory

Answer 39

theory attempts to explain how firms should choose capital structure that maximizes value of the firm. theory believes total value of leveraged firm equals value of firm without leverage plus the present value of the tax savings from debt, less present value of financial distress costs, plus present value of agency benefits of debt

Question 40

define asset substitution problem

Answer 40

when shareholders can gain by making negative NPV investments or decisions that sufficiently increase the firms risk

Question 41

define debt overhang

Answer 41

when a firm may be unable to finance new, positive NPV projects because it faces financial distress

Question 42

define free cash flow hypothesis

Answer 42

view that wasteful spending is more likely to occur when firms have high levels of free cash flow, or cash flow in excess of what is needed after making all positive npv investments and payments to debt holders. Under hyptohesis, leverage may increase firm value by reducing wasteful investment by managers because it commits the firm to making future interest payments reducing excess cash flow

Question 43

define management entrenchment

Answer 43

view that managers care most about keeping their jobs, and they are more likely to engage in wasteful investment when their postiion within the firm is secure. increasing leverage and the risk of distress may help control wasteful investment

Question 44

define asymmetric information

Answer 44

managers information about firm’s level of risk and future cash flows is superior to outside investors.

Question 45

define adverse selection

Answer 45

buyers will tend to discount price they are willing to pay for good when there is assymetric information - seller has private info about value of good. likely markets will contain low quality goods. investors discount price they’re willing to pay for securities if there’s asymmetric information

Question 46

define moral hazard

Answer 46

idea that individuals change their behavior if they are not fully exposed to consequences

Question 47

define signaling theory of debt

Answer 47

in the presence of asymmetric information, idea that firms can use high leverage as way to signal investors that they are undervalued. signal may be too costly for lower valued firms to send because will lead to higher expected costs of financial distress

Question 48

define pecking order hypothesis

Answer 48

idea that in the presence of asymmetric information and likelihood of percieved adverse selection, managers will choose to issue safest security they can and only issue new equity as last resort. in this theory, firms raising capital prefer using retained earnings, and then turn to debt before equity to avoid market perceiving them as being overvalued - attempting to issue overvalued securities.