Topic 4 Capital Structure III: Debt, Bankruptcy Costs and Managerial Agency Costs Flashcards
Takeaway If there are costs to financial distress, and managers have different interests than shareholders
-Leverage decreases the value of the firm through shareholders bearing the cost of financial distress, leverage prevents managers from engaging in wasteful spending thus it becomes the benefits of leverage against spending and the tax shield vs the cost of financial distress
Economic vs Financial Distress
Economic- when a firm has a significant decline in the value of assets
Financial- when a firm has difficulty meeting its debt obligations
Default
Firm fails to make required payments to debt holders
US Bankruptcy Law
-Organized default process designed to treat creditors fairly and to avoid assets being needlessly destroyed
-Chapter 7
->Liquidation where a trustee is appointed and assets are sold in auction and proceeds are given to creditors in strict priority ultimately the firm ceases to exist
-Chapter 11
->Reorganization, pending collections are suspended and management has a chance to organize business; debt holders may get new securities and they must agree to reorganization or it will force the firm into chapter 7
Direct Costs of Bankruptcy
-Outside expects such as lawyers and bankers
-Creditors incur additional costs and time is needed to complete reorganization and receive payment
-generally 3-4% of pre-bankruptcy market value of total assets, generally a fixed costs so can be up to 12% in case of small firm
-solutions to decrease costs
->Workouts and or a pre-packaged bankruptcy where an agreement is reached before filling chapter 11
Indirect Costs of Bankruptcy
-Loss of Customer-> warranties, future support
-Loss of Suppliers->trade credit questionability
-Loss of Employees ->leaves firms paying expensive retention plans
-Loss of Receivables->people just don’t pay while firm is distracted
-Fire Sale of Assets-> average 15-40% lower price
-Inefficient Liquidation
-Costs to Creditors-> the creditors could be pushed into financial distress
*Estimated 10-20% of firm value cost
Financial Distress Costs Calculation 3 factors
1) Probability of financial distress
2) Magnitude of the costs when the firm is in distress -> varies by industry
3) Appropriate discount rate for the distress costs -> increases with firm’s market risk
Optimal Capital Structure within Trade-Off Theory
-Firm maximizes value by choosing a capital structure that balances the positive effect of the interest tax shied and the negative effect of financial distress costs
-Basically add debt until financial distress costs are greater than value of interest tax shield
Free Cash Flow hypothesis
-wasteful spending more likely to occur if there is easy access to free cash
-> thus leverage makes cash less accessible and reduces wasteful spending
