Section 12 Flashcards
what is bankruptcy caused by?
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
if bankruptcy is viewed as exogenous, how does the procedure play out in relation to management?
will leave management in place and, may even protect management
if bankruptcy is viewed as the result of managers actions, how does the procedure treat them?
tend to remove incumbent equity holders and management
why is bankruptcy code important?
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)
why does debt exist?
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
optimal bankruptcy rules preserve..?
going-concern value, but don’t entrench managers or equity holders. provide balance between exogenous and endogenous factors
if the bankruptcy rules aren’t designed well, what can happen?
one party or another can take advatnage of rules strategically to transfer value to themselves at the expense of others (Strategic bankruptcy filing)
in the mid 1970’s the US Congress passed?
Bankruptcy Reform Act of 1978
What did the Bankruptcy Reform Act of 1978 do?
easier for managers to invoke bankruptcy protection. Doesn’t require debtor actually be insolvent in order to file protection from creditors.
Passage of the 1978 act led to what?
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
prior to the act what was the relationship between filings and economic activity?
more filings were associated with recessions
after the act of 1978 what happened to the historical relationship?
no such association. act benefited a specific group by creating strategic option for one group
in the pre-1978 act era vs post, describe impacts to stockholders?
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
if Bond and stockholders losses were greater after the passage of the act, why did number of filings increase?
managers may have benefited. survival rate of firms went from 74% to 84%
the transfer of control from equity holders to bond holders that is supposed to occur when a firm becomes insolvent is governed by?
bankruptcy procedures. they regulate the transfer, but create strategic possibilities for various parties including managers
The firm is viewed as a nexus of contracts between?
economic players
what are the three types of economic players?
manager, equity holder, and debt holder
In the agency literature, who’s the manager?
the agent
in the agency literature, who’s the investors (equity and debt)?
principal
from a legal perspective, shareholders are or are not owners of the firm?
are owners
from a legal perspective, mangers may also be owners of firm?
may also be partial owners when they own stock in the firm
what’s the key assumption in the agency literature regarding each agents and their payoff?
each agent only maximizes their own payoff
should a firm never invest in a project with a negative beta?
no - a project with negative beta (has higher return than the CAPM return of a same beta portfolio) should be considered.
why are assets with negative beta valuable?
they reduce portfolio variance
In the presence of agency conflict, who dominates debt between creditors and equity holders?
equity
when the entrepreneur sells equity, he bears the full cost of effort but only receives…?
a fraction of the output
The more outside equity, the more severe is the..?
inefficient production problem, thus the lower value of the firm
what can solve the underproduction problem partially?
debt finance
describe chapter 7 liquidation
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
describe chapter 11 reorganization
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.
what are direct costs of bankruptcy?
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
what are indirect costs of bankruptcy?
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)
what are agency costs?
losses in value associated with having an agent with different interests work on behalf of the principals, or owners.
of all the different imperfections that drive capital structure, the most significant is likely to be..?
taxes: interest tax shield allows firms to repay investors and avoid corporate tax
firms must balance the tax benefits of debt with..?
costs of financial distress
agency costs and benefits of leverage are also important determinants of…? and why..?
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
define default
when firm fails to make required interest or principal payments on debt
define bankruptcy
court supervised reorganization of firms financial claims governed by 1978 reform act
define trade-off theory
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
define asset substitution problem
when shareholders can gain by making negative NPV investments or decisions that sufficiently increase the firms risk
define debt overhang
when a firm may be unable to finance new, positive NPV projects because it faces financial distress
define free cash flow hypothesis
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
define management entrenchment
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
define asymmetric information
managers information about firm’s level of risk and future cash flows is superior to outside investors.
define adverse selection
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
define moral hazard
idea that individuals change their behavior if they are not fully exposed to consequences
define signaling theory of debt
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
define pecking order hypothesis
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.
