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FINS3624 - L4 Financial Distress, Managerial Incentives, Information…

- - - - Wasteful spending may occur: cash flow is high after making +'ve NPV investments and debt holders
        
        Low cash - managers will try to be more efficient
        
        FCF hypothesis says leverage increases firm value as it locks in future interest payments, which reduce excess cash flows and wasteful investing.
    - - Overconfident investing
      - Empire Building
        
        Managers prefer to run larger firms
        
        Take on investments that increase size but maybe not profitability
      - Result of the separation of ownership & control between managers and investors. Managers make decisions that benefit themselves at the investor's expense.
      - Reducing Management Entrenchment:
        
        Leverage may reduce managerial entrenchment as managers may get fired during FD
        
        High leverage situations will cause creditors to monitor more closely.
  - - - $45k in debt
        
        New Investment Project: $10k setup; 20% risk free return
        
        r_f = 5%
        NPV = $10k 1.2 1.00 = $12k > 0. +'ve.
      - Shareholders
        
        Profit: $45 - $10 + $12 - $45 = $2
        
        Cost: $10k
        As a result, they wouldn't invest in this +'ve NPV project
        
        Debt Holders
        
        Receive the other $10k
      - Under-investment/Debt overhang Problem: Equity Holders don't invest in a +'ve NPV project for a firm in FD because the debt holders get the value.
        
        Cashing Out: In FD, shareholders may be paid dividends first by the managers. Manager know before banks the firm's dire situation.
- - - - Explains why some firms don't fully exploit the tax shield. The financial distress costs are too high.
  - - - Depend on firm's market risk
        
        PV(financial distress cost) higher for high beta firms
      - Might be the WACC.
        or the risk of distress happening?
    - - Tech firms: high financial distress costs - loss of customers/key personnel; lack of tangible assets for easy liquidation
        
        Real estate firms: low cost of financial distress - can easily most assets
    - - P(fin distress) inc. with % of liabilities to assets
        
        Inc. with volatility of cash flows & asset values
- - - - e.g. loss of customers/suppliers/employees, reputation damage
      - Hard to measure
        
        Often greater than direct costs of bankruptcy
        
        Financial distress estimated loss of 10%-20% (of firm value)
    - - Financial Distress Costs:
        With Leverage:
        
        Success: FDC = -$4000
        
        Failure: FDC = -$4000 - $6000 (bankruptcy cost)
    - - Equity holders, in bankruptcy, lose all their investment and don't care about bankruptcy costs. Take on risky investments.
        
        Debt holders know if the new product fails and the firm defaults, they will not get the full value of their assets.
        
        Will initially pay less for debt
        
        Less money for dividends, share repurchases, investments (equity holders pay)
      - Armin example
        Total value to investors:
        
        Failure without leverage: $80m
        
        Failure with leverage: $60m
        
        Direct cost: Loss due to unrecovered assets (< $150m)
        
        Indirect Cost: The $20m loss is due to financial distress costs (w/ leverage)
      - Capital Adequacy:
        
        Good exposure for $100m: $10m of equity required (up to 1:20)
        
        Bad exposure (default) for $100m: $100m of cash required (now 1 to 1)
    - - DESCRIPTION
        
        Direct cost of: ~3%-4% of pre-bankruptcy pre-bankruptcy market value of total assets
        
        Fees of an atorney
        
        Fees of filing bankruptcy
        
        Credits incur costs:
        
        Years to receive payment
        
        May hire own experts for legal/professional advice
        
        Costly outside experts are hired
        
        US Bankruptcy code created so creditors are treated fairly & assets not needlessly destroyed
        
        Both direct & indirect costs are imposed on investors
        
        In reality, bankruptcy is long and complicated
        
        ATO can garnish accounts. BHP & Rinto. Make their debitors pay ATO instead of the companies.
      - Ch 7: Liquidation
        
        Trustee appointed to oversee liquidation of firm's assets through an auction
        
        Liquidation proceeds used to pay the firm's creditors. Firm ceases to exist.
      - Ch11: Reorganisation
        
        More common for large corps.
        
        All pending collection attempts suspended
        
        Firm's management proposes reorganisation plan
        
        Creditors receive less than owed but more than if they shut down immediately
        
        Creditors must vote to accept plan & bankruptcy court must approve
        
        If Chapter 11 is declined, Chapter 7 Liquidation may be forced
  - - - Without leverage:
        
        Equity holders lose $70m if fail
        
        With leverage:
        
        Equity holders lose $50m if fail
        
        Debt holders lose $20m if fail
        
        Total loss still adds up to $70m
        
        MM Proposition I: With perfect capital markets, total value of all investors is independent of a firm's capital structure.
    - - Without leverage: Equity holders own full amount ($80m). Debt Holders $0.
        
        With Leverage: Armin experiences financial distress and defaults
        
        Bankruptcy:
        
        debt holders receive legal ownership of firm's assets. They gain $80m in assets and lose $20m.
        
        equity holders receive nothing
    - - Without leverage: Equity Holders own full amount ($150m). Debt Holders $0.
        
        With leverage: Armin makes $100m debt payment; Equity holders own $50m.
        
        Armin does not have $100m cash at end of year: Take new loan / issue shares.
  - - - Investment cash flows are independent of financing choices
      - No tax & transaction costs
      - Securities are fairly Priced
    - - Equity financing does not carry risk of bankruptcy.
        Equity holders may receive dividends, but not obligated.
      - Leverage comes with risk of bankruptcy.
    - - After Default:
        
        Debt holders have rights to assets of the firm - may take legal ownership of firm's assets through bankrupcy
      - Firm fails to make interest/principal payments on debt
    - - Firm has difficulty meeting debt obligations