4211: Costs of Financial Distress

Describe the probability of financial distress.

- Increases with the likelihood that firm will default - Increases with the amount of a firm's liabilities (relative to assets) - Increases with the volatility of a firm's cash flows and assets values - Firms with steady, reliable cash flows have a low probability of default - FIrms with volatile cash flows have a higher probability of default, all else equal.

What are the effects of leverage on firm value?

- Raising leverage increases PV(Tax Shield), increasing the firm value - Raising leverage increases PV(Distress Costs), reducing the firm value - The firm should set leverage to maximize total firm value VL by issuing debt until the point that firm value starts declining with additional leverage

What are the two types of bankruptcy in the US?

1) Chapter 7 2) Chapter 11

What are the costs of debt?

1) Higher likelihood of costly bankruptcy - direct costs (e.g., lawyers) - Indirect costs (e.g., lost business relationships) 2) Bad Incentives ("Agency Costs")

What are the indirect costs of bankruptcy?

1) Loss of Customers: Bankruptcy may enable the firm to walk away from future commitments (i.e. product support) to customers, so customers may be unwilling to purchase products whose value depends on future support or service - Example: Software firm may not support product, so customers move to competitors 2) Loss of Suppliers: Suppliers may be unwilling to provide a firm with inventory if they fear they will not get paid, which raises the cost of operating for the firm - Example: Swiss Air shut down in 2001 because suppliers refused to fuel its planes. 3) Cost to Employees: Significant number of employees are laid off in bankruptcy, so employees are less willing to work for a firm with significant bankruptcy risk. - Example: PG&E paid $80 million to retain 17 key employees in 2003. 4) Fire Sale of Assets: Companies in distress may have to sell assets quickly to raise cash, possibly accepting a lower price than the assets are worth to the firm.

What are the direct costs of bankruptcy?

1) The bankruptcy process is complex and requires professional help to navigate - Firms have to pay lawyers, consultants, appraisers, and investment bankers - Creditors also hire lawyers and consultants to ensure their rights are respected 2) From a time value perspective, creditors may wait years for the bankruptcy to be resolved and to receive payment for what they are owed Whoever pays these costs, they reduce the total amount received by investors

What does the tradeoff theory explain?

1) The presence of financial distress costs can explain why firms choose debt levels that are too low to fully exploit the interest tax shield 2) Differences in the magnitude of financial distress costs and the volatility of cash flows can explain the differences in the use of leverage across industries

What two key factors determine the present value of financial distress costs?

1) The probability of financial distress 2) The magnitude of the bankruptcy costs, if the firm defaults ("loss given default")

How much are indirect costs of bankruptcy estimated to be?

10 to 20% of firm value. Much larger than direct costs!

How much are direct costs of bankruptcy estimated to be?

3-4% of the pre-bankruptcy market value of the firm's assets - Absolute costs are higher for larger, more complex firms - Relative cost (i.e. % of firm value) are higher for small firms, as many costs are fixed - United Airlines spent $8.6 million per month on bankruptcy advisors from 2003 to 2005

What gives rise to the pecking order theory?

Asymmetric information and indirect costs mean that internal cashflow > debt > equity.

What is the main reason firms are cautious in their debt usage?

Bankruptcy costs. - Perfect capital markets assume there are no bankruptcy costs, but there are both direct and indirect costs.

Describe the magnitude of financial distress.

Depends on the nature of the firm's business. - Firms that rely on customer service, supplier relationships, or highly skilled workers have high distress costs. - Firms with lots of tangible assets (i.e. property, plant, and equipment) have low distress costs because they can easily sell assets for close to fair value while firms with intangible or specific assets have to sell at a discount.

How does a firm determine the optimal capital structure with distress costs?

Have to think about PV(Distress Costs), the present value of expected future distress costs

What is bankruptcy?

If a firm in financial distress defaults, the firm enter bankruptcy, which is long and costly legal process. - Outside professionals are generally hired. - The creditors may also incur costs during the process. They often wait several years to receive payment.

Describe Chapter 7 bankruptcy.

Piecemeal liquidation of the firm's assets. - Trustee is appointed to sell off all of the firm's assets in an auction. - Proceeds from liquidation are used to pay creditors according to the Absolute Priority Rule: - the different claims issued by a firm have varying levels of seniority - In bankruptcy, senior claims should be fully satisfied before junior claims receive any value

Describe Chapter 11 bankruptcy.

Reorganization of the business. - Collection attempts are suspended and management proposes a reorganization plan - While developing the plan, management continues to operate the business - In addition to cash payment, creditors receive equity in the reorganized firm - Reorganization is preferable to liquidation because the firm has value as a going concern - If an acceptable plan is not negotiated, then the court may force Chapter 7 liquidation

True or False: Direct issuance costs favor some types of capital over others.

TRUE. Direct issuance costs make debt cheaper than equity.

Do technology firms have high or low costs of financial distress?

Technology firms have high costs of financial distress, as they rely on key employees, customer support is an important element in their business, and they have little in terms of tangible assets.

Do utilities and airlines have high or low costs of financial distress?

Utilities and airlines have low costs of financial distress because much of their value derives from tangible assets (power and water plants, airplanes) that can be sold if necessary.

What is the equation for the total value of the levered firm?

VL = VU + PV(Tax Shield) - PV(Distress Costs)

What is financial distress?

With higher leverage, the firm is less likely to be able to make interest payments, or more likely to default on its debt obligations. A firm that is close to default is in financial distress.