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CFS C12TX: Financial Distress, Managerial Incentives, and Information…
CFS C12TX: Financial Distress, Managerial Incentives, and Information
intro: when a firm has trouble meeting its debt obligations we say the firm is in financial distress
- Default and bankruptcy in a perfect market
a. Armin Industries: Leverage and the Risk of Default
- Scenario 1: New product succeeds
- Scenario 2: New product fails
- Comparing the two scenarios (economic distress)
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- The costs of bankruptcy and financial distress
a. The bankruptcy code
- liquidation
- reorganization
b. direct costs of bankruptcy
- workout
- prepackaged bankruptcy (or prepack)
c. indirect costs of financial distress
- loss of customers
- loss of suppliers (debtor-in-possession (DIP) financing )
- loss of employees
- loss of receivables
- fire sales of assets
- inefficient liquidation
- costs to creditors
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- financial distress costs and firm value
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b. 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
- Optimal Capital Structure: The Trade-off theory
According to this theory, the total value of a levered firm equals the value of the firm without leverage plus the present value of the tax savings from debt, less the present value of financial distress costs
a. the present value of financial distress costs
key factors
- the probability of financial distress
- the magnitude of the costs if the firm is in distress
- the appropriate discount rate for the distress costs
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- Exploiting debt holders: The agency costs of leverage
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- motivating managers: the agency benefits of leverage
this separation of ownership and control creates the possibility of management entrechment --- in the phrasing of Weisbach (1988): "Managerial entrenchment occurs when managers gain so much power that they are able to use the firm to further their own interests rather than the interests of shareholders."
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b. reduction of wasteful investment
- free cash flow hypothesis
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- agency costs and the trade-off theory
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b. debt levels in practice
- the trade-off theory explains how firms should choose their capital structures to maximise value to current shareholders
- management entrenchment theory
- Asymmetric Information and Capital Structure
a. Leverage as a Credible Signal
- credibility principle: Claims is one's self-interest are credible only if they are supported by actions that would be too costly to take if the claims were untrue
- actions speak louder than words
- signaling theory of debt
b. issuing equity and adverse selection
- adverse selection: the selection of cars sold in the used-car market is worse than average
- adverse selection leads to the lemons principle: when a seller has private information about the value of a good, buyers will discount the price they are willing to pay due to the adverse selection
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- Capital structure: the bottom line
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