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Finance Test Chapter 16
Terms in this set (27)
When a firm has difficulty meeting its debt obligations
When a firm fails to make the required interest or principal payments on its debt, or violates a debt covenant
After the firm defaults, debt holders are given certain rights to the assets of the firm and may even take legal ownership of the firm's assets through bankruptcy.
An important consequence of Leverage!
The RISK OF BANKRUPTCY
Perfect Market vs. Reality
• With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total value to all investors does not depend on the firm's capital structure.
• There is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure.
• The bankruptcy only shifts the ownership of the firm from equity holders to debt holders
• IN REALITY, bankruptcy: both DIRECT and INDIRECT costs on the firm and its investors.
A trustee is appointed to oversee the liquidation of the firm's assets through an auction. The proceeds from the liquidation are used to pay the firm's creditors, and the firm ceases to exist
Chapter 11 is the more common form of bankruptcy for large corporations.
- All pending collection attempts are automatically suspended, and the firm's existing management is given the opportunity to propose a reorganization plan.
• While developing the plan, management continues to operate the business.
- The reorganization plan specifies the treatment of each creditor of the firm.
- Creditors may receive cash payments and/or new debt or equity securities of the firm.
• The value of the cash and securities is typically less than the amount each creditor is owed, but more than the creditors would receive if the firm were shut down immediately and liquidated.
- The creditors must vote to accept the plan, and it must be approved by the bankruptcy court.
- If an acceptable plan is not put forth, the court may ultimately force a Chapter 7 liquidation
Direct Costs of Bankruptcy
- The direct costs of bankruptcy reduce the value of the assets that the firm's investors will ultimately receive -
*Costly outside experts are often hired by the firm to assist with the bankruptcy process
* Creditors also incur costs during the bankruptcy process.
---They may wait several years to receive payment.
---They may hire their own experts for legal and professional advice.
Alternatives to bankruptcy due to direct costs
Given the direct costs of bankruptcy, firms may avoid filing for bankruptcy by first negotiating directly with creditors.
a firm in financial distress negotiates directly with its creditors to reorganize
2)Prepackaged Bankruptcy (Prepack):
a firm first develops a reorganization plan with the agreement of its main creditors and then files Chapter 11 to implement the plan
Indirect Costs of Financial Distress
While the indirect costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy.
- Loss of Customers - Loss of Suppliers - Loss of Employees - Loss of Receivables - Fire Sale of Assets - Inefficient Liquidation - Costs to Creditors
Who Pays for Financial Distress Costs?
When securities are fairly priced, the original shareholders of a firm pay the present value of the costs associated with bankruptcy and financial distress
The Optimal Capital Structure:
The firm picks the capital structure by trading off the benefits of the tax shield from debt against the cost of financial distress and agency cost
V(L) = V(U) + PV(interest tax shield) - PV(financial distress costs)
Three key factors determine the present value of financial distress costs
1. The probability of financial distress
• increases with the amount of a firm's liabilities (relative to its assets).
• increases with the volatility of a firm's cash flows and asset values.
2. The magnitude of the costs
• vary by industry: Technology firms vs. Real estate
3. The appropriate discount rate
• Depends on the firm's market risk
- The present value of distress costs will be higher for high beta firms.
• The tradeoff theory can help explain:
- Why firms choose debt levels that are too low to fully exploit the interest tax shield (due to the presence of financial distress costs)
- Differences in the use of leverage across industries (due to differences in the magnitude of financial distress costs and the volatility of cash flows)
Agency costs are losses in value associated with having an agent with different interests work on behalf of the principals, or owners. In the context of a firm with leverage, a conflict of interest may exist because investment decisions may have different consequences for debt holders and equity holders.
In some circumstances, managers may have an incentive to take actions, such as excessive risk taking, under-investment, or cashing out, that benefit equity holders but harm the firm's creditors and lower the total value of the firm
When a firm faces financial distress, shareholders can gain at the expense of debt holders by taking a negative-NPV project, if it is sufficiently risky.
Under-investment Problem (Debt overhang problem)
A situation in which equity holders choose not to invest in a positive NPV project because the firm is in financial distress and the value of undertaking the investment opportunity will accrue to bondholders rather than themselves. - This is also called a debt overhang problem.
When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm, if possible.
- For example, if it is likely the company will default, the firm may sell assets below market value and use the funds to pay an immediate cash dividend to the shareholders.
Motivating Managers (Agency benefits of leverage)
Using debt financing as a source of capital can also enhance a firm's value beyond just the tax shields from interest!
Free Cash Flow Hypothesis:
For example, managers (the agents of the shareholders) of unlevered firms with excessive free cash flow, beyond what is needed to fund all positive NPV projects, may be motivated to spend the cash on things that benefit themselves, such as corporate jets and value-decreasing acquisitions, for the sake of empire building.....
If such firms have high leverage, they will have LESS FREE CASH FLOW and thus LESS OF AN OPPORTUNITY TO MAKE SUCH VALUE-DECREASING INVESTMENTS.
Leverage and Commitment:
In addition, when managers are shareholders in their firm, shareholder concentration can be maintained by issuing new debt instead of new equity, or increased by replacing some equity with debt......
Managers that own a higher percentage of a firm's equity will have a better chance of making decisions that maximize the value of the stockholders' investment.
Types of firms and debt levels
The trade-off theory implies that mature, low-growth firms with stable cash flows and tangible assets should use more debt because they can use the tax shields and would incur lower costs if distress occurs,
Firms with unstable cash flows and lots of intangible assets should use little or no debt because the probability and cost of financial distress are high.
A situation in which parties have different information
- For example, when managers have superior information to investors regarding the firm's future cash flows
Can lead to ADVERSE SELECTION
Buyers tend to discount the price they are willing to pay for a firm's securities because investors cannot determine whether the firm is under- or over valued
To overcome asymmetric information and adverse selection, firms may send signals to investors that show the health of the company.
1) The USE OF LEVERAGE as a way to signal information to investors
• A firm can use leverage as a way to convince investors that it does have information that the firm will grow, even if it cannot provide verifiable details about the sources of growth.
Other signals may be thrown that say a company isn't doing well!
1) Only those managers who know their firms have poor prospects (and whose securities will have low value) are willing to SELL NEW EQUITY.
- Due to the lemon principle, buyers are reluctant to believe management's assessment of the new projects and are only willing to buy the new equity at heavily discounted prices.
• Therefore, managers who know their prospects are good (and whose securities will have a high value) will not sell new equity
Implications for Equity Issuance
The lemons principle directly implies that:
- The stock price declines on the announcement of an equity issue.
- The stock price tends to rise prior to the announcement of an equity issue.
- Firms tend to issue equity when information asymmetries are minimized, such as immediately after earnings announcements.
Implications for Capital Structure
Managers who perceive the firm's equity is underpriced will have a preference to fund investment using retained earnings, or debt, rather than equity
PECKING ORDER HYPOTHESIS:
The idea that managers will prefer to fund investments by first using retained earnings, then debt and equity only as a last resort
Capital Structure: The Bottom Line
The optimal capital structure depends on market imperfections, such as taxes, financial distress costs, agency costs, and asymmetric information.
With perfect capital markets, does the possibility of bankruptcy put debt financing at a disadvantage?
The total value to all investors does not depend on the firm's capital structure. Investors as a group are not worse off because a firm has leverage.
While it is true that bankruptcy results from a firm having leverage, bankruptcy alone does not lead to a greater reduction in the total value to investors. Thus, there is no disadvantage to debt financing, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure.
If a firm files for bankruptcy under Chapter 11 of the bankruptcy code, which party gets the first opportunity to propose a plan for the firm's reorganization?
If a firm files for bankruptcy under Chapter 11, the firm's existing management is given the first opportunity to propose a reorganization plan
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