Week 2: Limits to the Use of Debt & Financial Distress Costs Flashcards
What is financial distress?
Occurs when promises to creditors broken/honoured w difficulty –> increased cost of financing may lead to bankruptcy/default.
How does financial distress in terms of direct bankruptcy costs affect firm value?
DIRECT COSTS ASSOCIATED W BANKRUPTCY -VELY AFFECTS FIRM VALUE: Firm value = (firm value if only equity finance used) + PV of tax shields - (PV of financial distress cost)
How do the incentives of equity holders & debtholders differ?
Equity holders typically seek to max the value of ownership stake i.e. stock price –> however in levered firm there may be conflicts between debt & equity holders e.g. equity holders may pursue riskier strategies w potential to increase stock prices but could also increase likelihood of financial distress/bankruptcy, which would -vely impact debt holders.
What are the 2 forms of financial distress in terms of bankruptcy costs?
1) Direct bankruptcy costs: e.g. accountancy costs, legal costs, administrative costs.
2) Indirect bankruptcy costs: distortions in investment strategies due to conflicts of interest between debt & equity holders –> levered corporation always chooses projects w +ve NPV but levered firm may deviate from this policy i.e. agency costs of debt.
What are the 4 forms of agency costs of debt when there is leverage in a company?
1) Asset substitution –> equity holders have tendency to take on overly risky projects, even w -ve NPV –> conflict of interest between bondholders & equity holders —> shareholders have power to put pressure on management to take on high-risk project over low-risk project in search of higher equity returns despite having -ve NPV, increasing risk of financial distress & being worse for bondholders as riskier assets may be insufficient to cover firm’s debt obligations —> stockholders are residual claimants so prefer that firms takes on higher risk.
2) Debt overhang —> equity holders may underinvest i.e. pass up profitable (+ NPV) investments due to firm’s existing debt capturing majority of project’s benefits –> companies w high financial distress/default risk struggle to raise financing via more debt issuance —> equity holders should provide more financing but not willing to do so as they contribute whole amount of financing for project but payoffs are shared between equity holders & debt holders–> any additional cash flows created by new investments would first need to be used to service existing debt obligations e.g. interest payments an& principal repayments so marginal cost for equity holders > marginal value for equity holders (despite being +ve NPV project) –> conflict of interest between equity holders & debt holders preventing firm taking on +ve NPV project.
3) Short-sighted investment problem –> equity holders may prioritize investment projects offering quick returns over those w longer payback periods, even if longer projects promise higher profitability in long run –> profitable investment opportunities requiring longer-term commitments e.g. R&D initiatives, infrastructure upgrades, or market expansion projects, may be underinvested in –> may impact firm’s long-term growth & sustainability –> may erode long-term shareholder wealth –> may increase risk of financial distress/default & harm interests of debt holders –> agency costs arise from conflict between interests of equity holders seeking immediate returns & debt holders relying on firm’s long-term viability to ensure repayment of their debt.
4) Reluctance to liquidate –> equity holders may be reluctant to liquidate a firm even when its operating value (value of ongoing operations) < liquidation value (value of its assets if sold off) –> equity holders may wait for mkt conditions to improve however prolonging operation of financially troubled firm can exacerbate losses for both equity holders (incur greater losses by holding onto declining asset)
& debt holders (face prolonged uncertainty & reduced recovery prospects in event of eventual liquidation) –> trade-off between equity holders prioritising personal interests or managerial discretion, and & debt holders who seek to max. recovery on their investments through timely liquidation/restructuring.
Who bears the cost of the equity-holder inventive problems (agency costs of debt)?
Debtholders due to higher cost of debt financing –> when lenders anticipate equity holders may take actions reducing value of the lenders’ claims e.g. increasing risk or siphoning off assets, they may demand compensation for this risk in form of higher interest rates on loans.
How can equity holders expropriate debt holder wealth?
When equity holders instruct firm’s managers to engage in actions prioritising interests of equity holders over debt holders –> e.g. asset stripping where equity holders pressuring managers to sell off valuable firm assets & distribute proceeds as dividends to shareholders, leaving firm w insufficient assets to cover its debt obligations i.e. collateral –> transfers wealth from debt holders to equity holders.
What are the 6 ways firms can minimise debt holder-equity holder incentive problems (agency costs of debt)?
1) Protective covenants –> contractual clauses included in debt agreements aiming to protect interests of debt holders by limiting value-destroying actions of equity holders, e.g. by placing limitations on additional borrowing, dividend payments, asset sales, or capital expenditures –> can help mitigate agency conflicts between debt & equity holders.
2) Bank & privately held debt –> relying more on bank loans or privately held debt rather than issuing publicly traded bonds as they have closer monitoring & direct involvement from lenders, which can help align interests of debt holders & equity holders i.e. less info asymmetries –> can also allow for more flexibility in negotiating terms & covenants tailored to specific needs of firm.
3) Use of short-term instead of long-term debt –> can reduce commitment horizon for debt holders & provide greater flexibility for equity holders as short-term debt typically has lower monitoring costs & fewer restrictive covenants –> reduces potential for debt-equity holder conflicts over time but may increase refinancing risk & interest rate volatility.
4) Security design –> firms can design debt securities with features aligning interests of debt & equity holders e.g. convertible bonds allow debt holders to convert their bonds into equity at a predetermined price, giving them a stake in firm’s future performance –> incentivises debt holders to support value-enhancing actions by equity holders due to potential gain.
5) Project financing –> involves securing debt financing specifically for particular project/asset, with cash flows generated by project used to repay debt –> isolates debt & cash flows associated w specific project so firms can minimise risk of cross-subsidisation between projects & mitigate conflicts between debt and equity holders.
6) Management compensation –> management compensation packages can be structured by firms to align interests of executives with those of debt & equity holders –> performance-based incentives e.g. stock options or bonuses tied to financial targets, can motivate managers to pursue value-maximizing strategies benefitting all stakeholders to help mitigate agency conflicts.
