Financial distress

Chapter 16 Chapter Outline

16.1 Default and Bankruptcy in a Perfect Market
Financial Distress, 16.2 The Costs of Bankruptcy and
Managerial Financial Distress
Incentives,
and Information 16.3 Financial Distress Costs and Firm Value
16.4 Optimal Capital Structure:
The Tradeoff Theory

Copyright © 2011 Pearson Prentice Hall. All rights reserved. Copyright © 2011 Pearson Prentice Hall. All rights reserved.
16-2

16.1 Default and Bankruptcy
Chapter Outline (cont'd)
in a Perfect Market

16.5 Exploiting Debt Holders: The Agency Costs of • Financial Distress
Leverage – When a firm has difficulty meeting its debt obligations
16.6 Motivating Managers: The Agency Benefits of • Default
Leverage – When a firm fails to make the required interest or
principal payments on its debt, or violates a debt
16.7 Agency Costs and the Tradeoff Theory covenant
• After the firm defaults, debt holders are given certain
16.8 Asymmetric Information and Capital Structure rights to the assets of the firm and may even take legal
ownership of the firm’s assets through bankruptcy.
16.9 Capital Structure: The Bottom Line

Copyright © 2011 Pearson Prentice Hall. All rights reserved.
16-3 Copyright © 2011 Pearson Prentice Hall. All rights reserved.
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16.1 Default and Bankruptcy Armin Industries:
in a Perfect Market (cont'd) Leverage and the Risk of Default

• Armin is considering a new project.
• An important consequence of leverage is the risk
of bankruptcy. – While the new product represents a significant advance
over Armin’s competitors’ products, the products success
– Equity financing does not carry this risk. While equity is uncertain.
holders hope to receive dividends, the firm is not • If it is a hit, revenues and profits will grow, and Armin will
legally obligated to pay them. be worth $150 million at the end of the year.
• If it fails, Armin will be worth only $80 million.

• Armin may employ one of two alternative
capital structures.
– It can use all-equity financing.
– It can use debt that matures at the end of the year with
a total of $100 million due.

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Scenario 1: New Product Succeeds Scenario 2: New Product Fails

• If the new product is successful, Armin is worth • If the new product fails, Armin is worth only $80
$150 million. million.
– Without leverage, equity holders will lose $20 million.
– Without leverage, equity holders own the full amount.
– With leverage, Armin will experience financial distress
– With leverage, Armin must make the $100 million debt
and the firm will default.
payment, and Armin’s equity holders will own the
• In bankruptcy, debt holders will receive legal ownership of
remaining $50 million.
the firm’s assets, leaving Armin’s shareholders with
– With perfect capital markets, as long as the value of nothing.
the firm’s assets exceeds its liabilities, Armin will be – Because the assets the debt holders receive have a value of
$80 million, they will suffer a loss of $20 million.
able to repay the loan.
– If it does not have the cash immediately available, it
can raise the cash by obtaining a new loan or by
issuing new shares.

16-8

Table 16.1 Value of Debt and Equity with and
Comparing the Two Scenarios
without Leverage ($ millions)

• Both debt and equity holders are worse off if the
product fails rather than succeeds.
– Without leverage, if the product fails equity holders lose
$70 million.
– With leverage, equity holders lose $50 million, and debt
holders lose $20 million, but the total loss is the same,
$70 million.

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Comparing the Two Scenarios (cont'd) Bankruptcy and Capital Structure

• If the new product fails, Armin’s investors are • With perfect capital markets, Modigliani-Miller
equally unhappy whether the firm is levered and (MM) Proposition I applies: The total value to all
declares bankruptcy or whether it is unlevered investors does not depend on the firm’s capital
and the share price declines. structure.
• Note, the decline in value is not caused by • There is no disadvantage to debt financing, and a
bankruptcy: the decline is the same whether or firm will have the same total value and will be
not the firm has leverage. able to raise the same amount initially from
investors with either choice of capital structure.
– If the new product fails, Armin will experience economic
distress, which is a significant decline in the value of a
firm’s assets, whether or not it experiences financial
distress due to leverage.

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Textbook Example 16.1 Textbook Example 16.1 Example 16.1 (cont'd)

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16.2 The Costs of Bankruptcy
The Bankruptcy Code
and Financial Distress

• With perfect capital markets, the risk of • The U.S. bankruptcy code was created so that
bankruptcy is not a disadvantage of debt, rather creditors are treated fairly and the value of the
bankruptcy shifts the ownership of the firm from assets is not needlessly destroyed.
equity holders to debt holders without changing
the total value available to all investors. – U.S. firms can file for two forms of bankruptcy
protection: Chapter 7 or Chapter 11.
– In reality, bankruptcy is rarely simple and
straightforward. It is often a long and complicated
process that imposes both direct and indirect costs on
the firm and its investors.

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The Bankruptcy Code (cont'd) The Bankruptcy Code (cont'd)

• Chapter 7 Liquidation • Chapter 11 Reorganization
– A trustee is appointed to oversee the liquidation of the – Chapter 11 is the more common form of bankruptcy for
firm’s assets through an auction. The proceeds from the large corporations.
liquidation are used to pay the firm’s creditors, and the – With Chapter 11, all pending collection attempts are
firm ceases to exist. 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.

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The Bankruptcy Code (cont'd) Direct Costs of Bankruptcy

• Chapter 11 Reorganization • The bankruptcy process is complex, time-
– Creditors may receive cash payments and/or new debt or consuming, and costly.
equity securities of the firm. – Costly outside experts are often hired by the firm to
• The value of the cash and securities is typically less than assist with the bankruptcy process.
the amount each creditor is owed, but more than the
creditors would receive if the firm were shut down – Creditors also incur costs during the bankruptcy process.
immediately and liquidated. • They may wait several years to receive payment.
– The creditors must vote to accept the plan, and it must • They may hire their own experts for legal and
professional advice.
be approved by the bankruptcy court.
– The average direct costs of bankruptcy are
– If an acceptable plan is not put forth, the court may approximately 3% to 4% of the pre-bankruptcy
ultimately force a Chapter 7 liquidation. market value of total assets.

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Indirect Costs of Financial Distress Overall Impact of Indirect Costs

• While the indirect costs are difficult to measure • The indirect costs of financial distress may
accurately, they are often much larger than the be substantial.
direct costs of bankruptcy. – It is estimated that the potential loss due to financial
– Loss of Customers distress is 10% to 20% of firm value

– Loss of Suppliers – The incremental losses that are associated with financial
distress, above and beyond any losses that would occur
– Loss of Employees due to the firm’s economic distress, must be identified.
– Loss of Receivables
– Fire Sale of Assets
– Delayed Liquidation
– Costs to Creditors

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16.3 Financial Distress Costs Table 16.2 Value of Debt and Equity with and
and Firm Value without Leverage ($ millions)

• Armin Industries: The Impact of Financial
Distress Costs
– With all-equity financing, Armin’s assets will be worth
$150 million if its new product succeeds and $80 million
if the new product fails.
– With debt of $100 million, Armin will be forced into
bankruptcy if the new product fails.
• In this case, some of the value of Armin’s assets will be lost
to bankruptcy and financial distress costs.
• As a result, debt holders will receive less than $80 million.
• Assume debt holders receive only $60 million after
accounting for the costs of financial distress.

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16.3 Financial Distress Costs
Textbook Example 16.2
and Firm Value (cont'd)

• Armin Industries: The Impact of Financial
Distress Costs
– As shown on the previous slide, the total value to all
investors is now less with leverage than it is without
leverage when the new product fails.
• The difference of $20 million is due to financial
distress costs.
• These costs will lower the total value of the firm with
leverage, and MM’s Proposition I will no longer hold.

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Textbook Example 16.2 (cont'd) Who Pays for Financial Distress Costs?

• For Armin, if the new product fails, equity holders
lose their investment in the firm and will not care
about bankruptcy costs.
• However, debt holders recognize that if the new
product fails and the firm defaults, they will not
be able to get the full value of the assets.
– As a result, they will pay less for the debt initially (the
present value of the bankruptcy costs less).

16-28

Who Pays for Financial
Distress Costs? (cont'd)

• When securities are fairly priced, the original
shareholders of a firm pay the present value of
the costs associated with bankruptcy and financial
distress.

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16.4 Optimal Capital Structure:
Textbook Example 16.3 (cont'd)
The Tradeoff Theory

• According to the tradeoff 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.

V L = V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)

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Determinants of the Present Value Determinants of the Present Value
of Financial Distress Costs of Financial Distress Costs (cont'd)

Three key factors determine the present value of Three key factors determine the present value of
financial distress costs: financial distress costs:
1. The probability of financial distress. 2. The magnitude of the costs after a firm is in distress.
• The probability of financial distress increases with the • Financial distress costs will vary by industry.
amount of a firm’s liabilities (relative to its assets). – Technology firms will likely incur high financial distress costs
• The probability of financial distress increases with the due to the potential for loss of customers and key personnel,
as well as a lack of tangible assets that can be easily
volatility of a firm’s cash flows and asset values.
liquidated.
– Real estate firms are likely to have low costs of financial
distress since the majority of their assets can be sold
relatively easily.

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Determinants of the Present Value
Optimal Leverage
of Financial Distress Costs (cont'd)

Three key factors determine the present value of • For low levels of debt, the risk of default remains
financial distress costs: low and the main effect of an increase in leverage
3. The appropriate discount rate for the distress costs. is an increase in the interest tax shield.
• Depends on the firm’s market risk • As the level of debt increases, the probability of
– Note that because distress costs are high when the firm does
poorly, the beta of distress costs has the opposite sign to
default increases.
that of the firm.
– The higher the firm’s beta, the more negative the beta of its
distress costs will be
• The present value of distress costs will be higher for high
beta firms.

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Figure 16.1 Optimal Leverage with Taxes and
Optimal Leverage (cont'd)
Financial Distress Costs

• 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)

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Textbook Example 16.4 Textbook Example 16.4 (cont'd)

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16.5 Exploiting Debt Holders: 16.5 Exploiting Debt Holders:
The Agency Costs of Leverage The Agency Costs of Leverage (cont'd)

• Agency Costs • Consider Baxter, Inc., which is facing
– Costs that arise when there are conflicts of interest financial distress.
between the firm’s stakeholders – Baxter has a loan of $1 million due at the end of the
• Management will generally make decisions year.
that increase the value of the firm’s equity. – Without a change in its strategy, the market value of its
However, when a firm has leverage, managers assets will be only $900,000 at that time, and Baxter will
default on its debt.
may make decisions that benefit shareholders but
harm the firm’s creditors and lower the total
value of the firm.

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Excessive Risk-Taking and Over-investment
Excessive Risk-Taking and Over-investment
(cont'd)

• Baxter is considering a new strategy • The expected value of the firm’s assets under the
new strategy is $800,000, a decline of $100,000
– The new strategy requires no upfront investment, but it
has only a 50% chance of success.
from the old strategy.
• 50% × $1.3 million + 50% × $300,000 = $800,000
• If the new strategy succeeds, it will increase the
value of the firm’s asset to $1.3 million. • Despite the negative expected payoff, some
within the firm have suggested that Baxter should
• If the new strategy fails, the value of the firm’s go ahead with the new strategy.
assets will fall to $300,000. – Can shareholders benefit from this decision?

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Table 16.3 Outcomes for Baxter’s Debt and Excessive Risk-Taking and Over-investment
Equity Under Each Strategy ($ thousands) (cont'd)

• Equity holders gain from this strategy, even
though it has a negative expected payoff, while
debt holders lose.
– If the project succeeds, debt holders are fully repaid and
receive $1 million.
– If the project fails, debt holders receive only $300,000.
• The debt holders’ expected payoff is $650,000, a loss of
$250,000 compared to the old strategy.
– 50% × $1 million + 50% × $300,000 = $650,000

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Excessive Risk-Taking and Over-investment Excessive Risk-Taking and Over-investment
(cont'd) (cont'd)

• The debt holders $250,000 loss corresponds to • Over-investment Problem
the $100,000 expected decline in firm value due – When a firm faces financial distress, shareholders can
to the risky strategy and the equity holder’s gain at the expense of debt holders by taking a negative-
$150,000 gain. NPV project, if it is sufficiently risky.

• Effectively, the equity holders are gambling with • Shareholders have an incentive to invest in
the debt holders’ money. negative-NPV projects that are risky, even though
a negative-NPV project destroys value for the firm
overall.
– Anticipating this bad behavior, security holders will pay
less for the firm initially.

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Table 16.4 Outcomes for Baxter’s Debt and Equity
Debt Overhang and Under-investment
with and without the New Project ($ thousands)

• Now assume Baxter does not pursue the risky
strategy but instead the firm is considering an
investment opportunity that requires an initial
investment of $100,000 and will generate a risk-
free return of 50%.
• If the current risk-free rate is 5%, this investment
clearly has a positive NPV.
– What if Baxter does not have the cash on hand to make
the investment?
– Could Baxter raise $100,000 in new equity to make the
investment?

16-50

Debt Overhang and Under-investment (cont'd) Debt Overhang and Under-investment (cont'd)

• If equity holders contribute $100,000 to fund the • Under-investment Problem
project, they get back only $50,000.
– A situation in which equity holders choose not to invest
– The other $100,000 from the project goes to the debt in a positive NPV project because the firm is in financial
holders, whose payoff increases from $900,000 to $1 distress and the value of undertaking the investment
million. opportunity will accrue to bondholders rather than
– The debt holders receive most of the benefit, thus this themselves.
project is a negative-NPV investment opportunity for
equity holders, even though it offers a positive NPV for
• When a firm faces financial distress, it may
the firm. choose not to finance new, positive-NPV projects.
• This is also called a debt overhang problem.

16-52

Cashing Out Agency Costs and the Value of Leverage

• When a firm faces financial distress, • Leverage can encourage managers and
shareholders have an incentive to withdraw shareholders to act in ways that reduce firm
money from the firm, if possible. value.
– For example, if it is likely the company will default, the – It appears that the equity holders benefit at the expense
firm may sell assets below market value and use the of the debt holders.
funds to pay an immediate cash dividend to the – However, ultimately, it is the shareholders of the firm
shareholders. who bear these agency costs.
• This is another form of under-investment that occurs
when a firm faces financial distress.

16-54

Agency Costs
and the Value of Leverage (cont'd)

• When a firm adds leverage to its capital structure,
the decision has two effects on the share price.
– The share price benefits from equity holders’ ability to
exploit debt holders in times of distress.
– The debt holders recognize this possibility and pay less
for the debt when it is issued, reducing the amount the
firm can distribute to shareholders.
• Debt holders lose more than shareholders gain from these
activities and the net effect is a reduction in the initial share
price of the firm.

16-56

Textbook Example 16.6 (cont'd) Debt Maturity and Covenants

• The magnitude of agency costs often depends on
the maturity of debt.
– Agency costs are highest for long-term debt and smallest
for short-term debt.
• Debt Covenants
– Conditions of making a loan in which creditors place
restrictions on actions that a firm can take

• Covenants may help to reduce agency costs,
however, because covenants hinder management
flexibility, they have the potential to prevent
investment in positive NPV opportunities and can
have costs of their own.

16-58

16.6 Motivating Managers:
Concentration of Ownership
The Agency Benefits of Leverage

• Management Entrenchment • One advantage of using leverage is that it allows
– A situation arising as the result of the separation of the original owners of the firm to maintain their
ownership and control in which managers may make equity stake. As major shareholders, they will
decisions that benefit themselves at investors’ expenses have a strong interest in doing what is best for
• Entrenchment may allow managers to run the the firm.
firm in their own best interests, rather than in the
best interests of the shareholders.

16-60

Concentration of Ownership (cont'd) Concentration of Ownership (cont'd)

• Assume Ross is the owner of a firm and he plans • With leverage, Ross retains 100% ownership and
to expand. He can either borrow the funds needed will bear the full cost of any “perks,” like country
for expansion or raise the money by selling club memberships or private jets.
shares in the firm. If he issues equity, he will • By selling equity, Ross bears only 60% of the
need to sell 40% of the firm to raise the cost; the other 40% will be paid for by the new
necessary funds. equity holders.
– Thus, with equity financing, it is more likely that Ross
will overspend on these luxuries.

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Reduction of Wasteful Investment Reduction of Wasteful Investment (cont'd)

• A concern for large corporations is that managers • Managers may over-invest because they
may make large, unprofitable investments. are overconfident.
• Managers may engage in empire building. – Even when managers attempt to act in shareholders’
interests, they may make mistakes.
– Managers of large firms tend to earn higher salaries, and • Managers tend to be bullish on the firm’s prospects and
they may also have more prestige and garner greater may believe that new opportunities are better than they
publicity than managers of small firms. actually are.
• Thus, managers may expand unprofitable divisions, pay too
much for acquisitions, make unnecessary capital
expenditures, or hire unnecessary employees.

16-64

Reduction of Wasteful Investment (cont'd) Reduction of Wasteful Investment (cont'd)

• Free Cash Flow Hypothesis • Leverage can reduce the degree of managerial
– The view that wasteful spending is more likely to occur entrenchment because managers are more likely
when firms have high levels of cash flow in excess of to be fired when a firm faces financial distress.
what is needed after making all positive-NPV – Managers who are less entrenched may be more
investments and payments to debt holders concerned about their performance and less likely to
• When cash is tight, managers will be motivated engage in wasteful investment.
to run the firm as efficiently as possible. • In addition, when the firm is highly levered,
– According to the free cash flow hypothesis, creditors themselves will closely monitor the
leverage increases firm value because it commits the actions of managers, providing an additional layer
firm to making future interest payments, thereby
reducing excess cash flows and wasteful investment by
of management oversight.
managers.

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16.7 Agency Costs
and the Tradeoff Theory Figure 16.2 Optimal Leverage with Taxes, Financial
Distress, and Agency Costs
• The value of the levered firm can now be shown
to be

V L = V U + PV (Interest Tax Shield) − PV (Financial Distress Costs)
− PV (Agency Costs of Debt)+PV (Agency Benefits of Debt)

16-68

The Optimal Debt Level Debt Levels in Practice

• R&D-Intensive Firms • Although the tradeoff theory explains how firms
– Firms with high R&D costs and future growth should choose their capital structures to maximize
opportunities typically maintain low debt levels. value to current shareholders, it may not coincide
– These firms tend to have low current free cash flows and
with what firms actually do in practice.
risky business strategies. • The arguments of the tradeoff theory are static,
• Low-Growth, Mature Firms but there seems to be a dynamic component in
the choice of the optimal capital structure.
– Mature, low-growth firms with stable cash flows and
tangible assets often carry a high-debt load. • Real firms seem to change their capital structure
– These firms tend to have high free cash flows with few frequently and to converge towards an optimal
good investment opportunities. level only in the very long run.

16-70

16.8 Asymmetric Information
Leverage as a Credible Signal
and Capital Structure

• Asymmetric Information • Credibility Principle
– A situation in which parties have different information – The principle that claims in one’s self-interest are
credible only if they are supported by actions that would
– For example, when managers have superior information
be too costly to take if the claims were untrue.
to investors regarding the firm’s future cash flows
• “Actions speak louder than words.”
• Signaling Theory of Debt
– The use of leverage as a way to signal information to
investors
• Thus 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.

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Leverage as a Credible Signal (cont'd) Textbook Example 16.7

• Assume a firm has a large new profitable
project, but cannot discuss the project due
to competitive reasons.
– One way to credibly communicate this positive
information is to commit the firm to large future debt
payments.
• If the information is true, the firm will have no trouble
making the debt payments.
• If the information is false, the firm will have trouble paying
its creditors and will experience financial distress. This
distress will be costly for the firm.

16-74

Textbook Example 16.7 (cont'd) Issuing Equity and Adverse Selection

• Adverse Selection
– The idea that when the buyers and sellers have different
information, the average quality of assets in the market
will differ from the average quality overall

• 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 adverse selection.

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Issuing Equity Issuing Equity
and Adverse Selection (cont'd) and Adverse Selection (cont'd)

• A classic example of adverse selection and the • This same principle can be applied to the market
lemons principle is the used car market. for equity.
– If the seller has private information about the quality of – Suppose the owner of a start-up company offers to sell
you 70% of his stake in the firm. He states that he is
the car, then his desire to sell reveals the car is probably
selling only because he wants to diversify. You suspect
of low quality. the owner may be eager to sell such a large stake
– Buyers are therefore reluctant to buy except at heavily because he may be trying to cash out before negative
discounted prices. information about the firm becomes public.

– Owners of high-quality cars are reluctant to sell because
they know buyers will think they are selling a lemon and
offer only a low price.
– Consequently, the quality and prices of cars sold in the
used-car market are both low.

16-78

Issuing Equity Issuing Equity
and Adverse Selection (cont'd) and Adverse Selection (cont'd)

• Firms that sell new equity have private • Therefore, managers who know their prospects
information about the quality of the future are good (and whose securities will have a high
projects. value) will not sell new equity.
– However, due to the lemon principle, buyers are • Only those managers who know their firms have
reluctant to believe management’s assessment of the
poor prospects (and whose securities will have
new projects and are only willing to buy the new equity
at heavily discounted prices. low value) are willing to sell new equity.

16-80


16-82

Figure 16.3 Stock Returns Before
Implications for Equity Issuance
and After an Equity Issue

• 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.

16-84

Implications for Capital Structure Implications for Capital Structure (cont'd)

• Managers who perceive the firm’s equity is • Pecking Order Hypothesis
underpriced will have a preference to fund – The idea that managers will prefer to fund investments
investment using retained earnings, or debt, by first using retained earnings, then debt and equity
rather than equity. only as a last resort
– The converse is also true: Managers who perceive the – However, this hypothesis does not provide a clear
firm’s equity to be overpriced will prefer to issue equity, prediction regarding capital structure. While firms should
as opposed to issuing debt or using retained earnings, to prefer to use retained earnings, then debt, and then
fund investment. equity as funding sources, retained earnings are merely
another form of equity financing.
• Firms might have low leverage either because they are
unable to issue additional debt and are forced to rely on
equity financing or because they are sufficiently profitable
to finance all investment using retained earnings.

16-86


16-88

Implications for Capital Structure (cont'd) 16.9 Capital Structure: The Bottom Line

• Market Timing View of Capital Structure • The optimal capital structure depends on market
– The firm’s overall capital structure depends in part on imperfections, such as taxes, financial distress
the market conditions that existed when it sought costs, agency costs, and asymmetric information.
funding in the past. • The tradeoff theory assumes an optimal capital
structures that arises as the tradeoff of the tax
benefits of debt with the costs of distress and of
agency problems.
• In reality the chosen capital structure seems to
depend more on current financing costs, that
result out of problems of asymmetric information.

16-90

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