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Summary Managerial Finance and Accounting: Chapter 16 €2,99   In winkelwagen

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Summary Managerial Finance and Accounting: Chapter 16

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  • 5 september 2021
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  • 2021/2022
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Chapter 16 – Financial Distress, Managerial Incentives and Information


16.1 Default and Bankruptcy in a Perfect Market
- Default: A firm that fails to make the required interest payments on their debt is in default. In this situation
the debt holders are given right to some assets and in extreme case the legal ownership of all the assets.
This is called bankruptcy.
- Example: Armin Industries is a firm that faces high competition and a challenging business environment.
It will launch a new product. However, the company is not sure if the product will be a success or a
failure.
- If it is a hit, revenues and profits will grow, and Armin will be worth $150 million at the end of the year.
If it fails, Armin will be worth only $80 million. Armin Industries may employ one of two alternative
capital structures: (1) It can use all-equity financing or (2) it can use debt that matures at the end of the
year with a total of $100 million due.
- Scenario 1 (Succes): if the company uses all equity financing, the company is worth the full 150
million, if it uses leverage, the company will be worth 150-100 = 50 million. However, if the company
does not have enough cash available at the end of the year to pay back the 100 million, will it be forced
to default? - NO. As long as the value of the firm’s assets exceeds its liabilities, Armin will be able to
repay the loan.
- Scenario 2 (fail): If the new product fails, Armin is worth only $80 million. If the company has all-
equity financing, equity holders will be unhappy but there is no immediate legal consequence for the
firm. In contrast, if Armin has $100 million in debt due, it will experience financial distress. The firm
will be unable to make its $100 million debt payment and will have no choice except to default.
- Comparing the two scenario’s: Without leverage, if the product fails equity holders lose, 150 million -
80 million = 70 million. With leverage, equity holders lose $50 million, and debt holders lose $20
million, but the total loss is the same—$70 million. Overall, if the new product fails, Armin’s investors
are equally unhappy whether the firm is levered and declares bankruptcy or whether it is unlevered and
the share price declines.
- Economic distress: a significant decline in the value of a firm’s assets, whether or not it experiences
financial distress due to leverage. If the new product fails, Armin will experience economic distress.
Bankruptcy and Capital Structure
- In MM proposition I the total value to all investors does not depend on the firms capital structure and they
are not worse off if the firm has leverage. While it is true that bankruptcy results from a firm having
leverage, bankruptcy alone does not lead to a greater reduction in the total value to investors. Thus, there
is no disadvantage to debt financing.

16.2 The Costs of Bankruptcy and Financial Distress
- With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt—it shifts the ownership
of the firm from equity holders to debt holders (the value does not change). However, this description is
not realistic. Equity holders don’t just “hand the keys” to debt holders the moment the firm defaults on a
debt payment. It is a long and difficult process.
The Bankruptcy Code
- When the firm goes bankrupt and the assets have to be decided over the creditors, the value of the assets
will be destroyed and it will never be equally divided over the creditors (not fairly). Therefore, the
bankruptcy code was developed.
- Liquidation: a trustee is appointed to oversee the liquidation of the firm’s assets through an auction. The
proceeds from the liquidation are used to pay the firm’s creditors, and the firm ceases to exist.
- Reorganization: all pending collection attempts are automatically suspended, and the firm’s existing
management is given the opportunity to propose a reorganization plan. In addition to cash payment,
creditors may receive new debt or equity securities of the firm. The value of cash and securities is
generally less than the amount each creditor is owed, but more than the creditors would receive if the firm
were shut down immediately and liquidated. The creditors must vote to accept the plan, and it must be
approved by the bankruptcy court.

, Direct Costs of Bankruptcy
- When a corporation becomes financially distressed, outside professionals, such as legal and accounting
experts, consultants, appraisers, auctioneers, and others with experience selling distressed assets, are
generally hired. These experts are costly. The direct costs of bankruptcy reduce the value of the assets that
the firm’s investors will ultimately receive.
- Given the substantial legal and other direct costs of bankruptcy, firms in financial distress can avoid filing
for bankruptcy by first negotiating directly with creditors. There are two options:
- Workout: when a financially distressed firm is successful at reorganizing outside of bankruptcy.
- Prepackaged bankruptcy: a firm will first develop a reorganization plan with the agreement of its main
creditors, and then file to implement the plan. With a prepack, the firm emerges from bankruptcy quickly
and with minimal direct costs.
Indirect Costs of Financial Distress
- Aside from the direct cost, there are also, often larger amounts of indirect costs associated with financial
distress:
- Loss of customers: customers become sceptical in buying the companies products as it may go bankrupt.
- Loss of suppliers: Suppliers may also be unwilling to provide a firm with inventory if they fear they will
not be paid.
- Debtor-in-possession (DIP) financing: DIP financing is new debt issued by a bankrupt firm. Because
this kind of debt is senior to all existing creditors, it allows a firm that has filed for bankruptcy renewed
access to financing to keep operating.
- Loss of employees: because firms in distress cannot offer job security with long-term employment
contracts, they may have difficulty hiring new employees, and existing employees may quit or be hired
away.
- Loss of receivables: firms in financial distress tend to have difficulty collecting money that is owed to
them.
- Fire sales of assets: in an effort to avoid bankruptcy and its associated costs, companies in distress may
attempt to sell assets quickly to raise cash. They sell the assets for too less money.
- Inefficient liquidation: bankruptcy protection can be used by management to delay the liquidation of a
firm that should be shut down.
- Cost to creditors: Aside from the direct legal costs that creditors may incur when a firm defaults, there
may be other indirect costs to creditors. If the loan to the firm was a significant asset for the creditor,
default of the firm may lead to costly financial distress for the creditor.
Overall Impact of Indirect Costs
When indirect costs, however, we must remember two important points. First, we need to identify losses to
total firm value. Second, we need to identify the incremental losses that are associated with financial distress.

16.3 Financial Distress Costs and Firm Value
Armin Industries: The Impact of Financial Distress Costs
- Levered firms risk incurring financial distress costs that
reduce the cash flows available to investors:
The table shows, the total value to all investors is now
less with leverage than it is without leverage when the
new product fails. (80 mil-60 mil)
Who Pays for Financial Distress Costs?
- It is true that after a firm is in bankruptcy, equity holders
care little about bankruptcy costs. But debt holders are not foolish—they recognize that when 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. How much less? Precisely the amount they will ultimately give up—the present value of the
bankruptcy costs. But if the debt holders pay less for the debt, there is less money available for the firm to
pay dividends, repurchase shares, and make investments. That is, this difference is money out of the
equity holders’ pockets.

16.4 Optimal Capital Structure: The Tradeoff Theory
- Tradeoff theory: weighs the benefits of debt that result from shielding cash flows from taxes against the
costs of financial distress associated with leverage.

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