CHapter 15

Protective Covenants

As we discussed in a previous chapter, loan agreements and bond indentures frequently include protective covenants. These covenants should reduce the costs of bankruptcy, ulti- mately increasing the value of the fi rm. Thus, stockholders are likely to favor all reasonable covenants. To see this, consider three choices by stockholders to reduce bankruptcy costs.

Direct Bankruptcy Costs

Because of the expenses associated with bankruptcy, bondholders won't get all that they are owed. Some fraction of the firm's assets will "disappear" in the legal process of going bankrupt. These are the legal and administrative expenses associated with the bankruptcy proceeding. We call these costs direct bankruptcy costs

Consolidation of Debt

One reason bankruptcy costs are so high is that different creditors (and their lawyers) contend with each other. This problem can be alleviated by proper arrangement of bond- holders and stockholders

Indirect Bankruptcy Costs

The costs of avoiding a bankruptcy filing incurred by a fiancially distressed firm are called indirect bankruptcy costs

Value of claims against a firm

There is, however, an important difference between claims such as those of stockholders and bondholders on the one hand and those of government and potential litigants in lawsuits on the other. The first set of claims are marketed claims , and the second set are nonmarketed claims . One difference is that the marketed claims can be bought and sold in financial markets, and the nonmarketed claims cannot. When we speak of the value of the firm , we are referring just to the value of the marketed claims, VM , and not the value of nonmarketed claims, VN . What we have shown is that the total value: VT = S + B + G + L = VM + VN is unaltered. But, as we saw, the value of the marketed claims, VM , can change with changes in the capital structure.

Financial Distress Costs

We use the term financial distress costs to refer generically to the direct and indirect costs associated with going bankrupt and/or avoiding a bankruptcy filing.

Agency Costs

When a fi rm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies. These conflicts of interest, which are magnified when financial distress is incurred, impose agency costs on the fi rm. We describe three kinds of selfish strategies that stockholders use to hurt the bond-holders and help themselves. These strategies are costly because they will lower the market value of the whole fi rm.