Principles Of Corporate Finance Unit H Lectures PDF

Financial Distress MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Financial Distress and Bankruptcy • A firm is in financial distress when it is experiencing difficult...

Financial Distress MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Financial Distress and Bankruptcy • A firm is in financial distress when it is experiencing difficulty meeting its debt obligations (ie, interest and/or principal). • If the firm fails to make debt payments, it is in default or bankrupt or insolvent. • Bankruptcy/insolvency is the legal process by which control of a bankrupt firm’s assets is handed over to its creditors. Costs of Financial Distress Costs of financial distress (CFD) are costs that arise from the bankruptcy process or from distorted business decisions before bankruptcy. These costs can be: • Direct: legal and administrative costs of bankruptcy • Indirect: losses from customers/suppliers/employees abandoning firm, and poor investment/operating decisions prior to bankruptcy or while bankruptcy is being resolved • Just the threat of bankruptcy can generate indirect costs. The End Practice 1: Financial Distress and Valuation Example: Default Without Bankruptcy Costs, Part I • Same set-up as in the “Applying MM” capital structure example; project with: • Required investment = 60 • Cash flow in one year is 100 or 60 with equal probability (50%) • Required return on asset: ra = 15% • Increase leverage enough so that default occurs in the bad state • Assume value of debt today: D = 60 • Continue to assume that βD = 0 and rD = 6.6% • Question: What is the value of the firm and its equity? Example: Default Without Bankruptcy Costs, Part II MM Proposition I approach • Unlevered firm value: VU = 100 × 0.5 + 60 × 0.5 ≈ 69.57 1.15 • No bankruptcy costs → MM Proposition I applies, so: VL = VU = 69.57 • Value of levered equity: EL = VL − D = 69.57 − 60 = 9.57 Example: Default Without Bankruptcy Costs, Part III MM Proposition II approach • Simultaneously solve the following system of equations for EL and rE : rE = rU + D 60 (rU − rD ) = 0.15 + (0.15 − 0.066) EL EL EL = E (CF to Equity) 1 + rE • Slight hiccup: right now, we do not know the expected cash flow to equity! (1) (2) Example: Default Without Bankruptcy Costs, Part IV MM Proposition II approach • For the expected cash flow to equity, first determine the promised payment to debtholders in the good state (ie, the face value of the debt). • Since rD = 6.6%, we know that: D (1 + rD ) = 60 × 1.066 ≈ 64 • Debtholders only receive 60 in the bad state, so the face value F must satisfy: F × 0.5 + 60 × 0.5 = 64 • So, F = 68. Example: Default Without Bankruptcy Costs, Part V Today Total CF CF to debt CF to equity Next year Bad state Good state Expected CF 0 60 100 80 −60 60 68 64 60 0 32 16 Example: Default Without Bankruptcy Costs, Part VI MM Proposition II approach • We can now solve our two equations: 60 (0.15 − 0.066) EL 16 EL = 1 + rE rE = 0.15 + • rE = 67.88% and EL = 9.57, so VL = 60 + 9.57 = 69.57 = VU MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Example: Default With bankruptcy costs • Now assume that if bankruptcy occurs, the firm must pay 7% to lawyers (direct bankruptcy costs). • This implies that in the bad state the asset cash flow to investors is equal to 56 (≈ 0.93 × 60) instead of 60. • Question: What is the value of the firm and its equity? The End Modelling 1: Financial Distress and Valuation Example: Default With Bankruptcy Costs, Part I • Now assume that if bankruptcy occurs, the firm must pay 7% to lawyers (direct bankruptcy costs). • This implies that in the bad state the asset cash flow to investors is equal to 56 (≈ 0.93 × 60) instead of 60. • Question: What is the value of the firm and its equity? Example: Default With Bankruptcy Costs, Part II MM Proposition I approach • Incorporating bankruptcy costs, firm value is: VL = 100 × 0.5 + 56 × 0.5 ≈ 67.83 1.15 • Value of levered equity: EL = VL − D = 67.83 − 60 = 7.83 Example: Default With Bankruptcy Costs, Part III MM Proposition II approach • Again, we need the face value of the debt. • Since rD = 6.6%, we know that: D(1 + rD ) = 60 × 1.066 ≈ 64 • But debtholders now only receive 56 in the bad state, so: F × 0.5 + 56 × 0.5 = 64 • So, F = 72. Example: Default With Bankruptcy Costs, Part IV Today Total CF CF to debt CF to equity Next year Bad state Good state Expected CF 0 56 100 78 −60 56 72 64 60 0 28 14 Example: Default With Bankruptcy Costs, Part V MM Proposition II approach • Solving the system of simultaneous equations again: rE = 0.15 + 60 (0.15 − 0.066) EL EL = 14 1 + rE • rE = 79.69% and EL = 7.83 (same as MM I approach) Bankruptcy Cost Example: Summary Compare the respective values of the firm, debt, and equity with and without bankruptcy costs. • Firm value fell by 1.74 (= 69.57 − 67.83). • The decline in firm value is equal to the present value of future bankruptcy costs: PV (Bankruptcy costs) = 0.5 × 0 + 0.5 × 4 = 1.74 1.15 • Value of debt remained the same at 60. • Value of equity declined by the same amount as firm value: 1.74 (= 9.57 − 7.83). CFD Example Conclusions 1. Bankruptcy costs are paid by shareholders. Why? • With bankruptcy costs, debtholders know they will get less if the firm defaults. • So they demand more (a larger face value) in the event that the firm does not default (otherwise, no lending). • This leaves less money for shareholders in good times. • The value of equity decreases. CFD Example Conclusions (cont.) 2. Direct bankruptcy costs are relatively small. • In the example, the expected bankruptcy costs reduce firm value by only 2.5% (= 1.74/69.57). • Why is this reduction in value less than the 7% (or $4) above? • Bankruptcy is not a certainty. • Bankruptcy occurs in the future. • Riskiness of equity increases (to 79.69% from 67.88%) resulting in deeper risk-adjusted discounting. • Empirically, it is 3% to 4% of assets or 20% of the market value of equity at the time of bankruptcy . • Direct bankruptcy costs seem second-order compared with the tax shield benefit. Indirect Bankruptcy Costs Indirect bankruptcy costs can be considerably larger than the direct costs. Indirect costs include: • Deterioration of business environment in expectation of bankruptcy • Poorer prices for products (no guarantees) • Poorer prices from suppliers (no trade credit) • Problems hiring and retaining employees • Fire sale of assets • Poor investment decisions arising from conflicts of interest between the stakeholders of the firm • Asset substitution • Debt overhang • Can be facilitated by bankruptcy laws The End Debt and Incentives: Debt vs Equity MM Assumptions 1. Investment is held constant 2. No transaction costs 3. No taxes 4. No bankruptcy costs 5. Efficient capital markets 6. Managers maximise shareholders’ wealth Conflicts of Interest: Creditors vs Shareholders • Agency costs: costs arising from conflicts of interest between stakeholders in a firm • In firms with leverage, conflicts of interest can emerge between shareholders and debtholders when projects have different consequences for their respective pay-offs • The costs created by this conflict can be especially acute when a firm is already in or facing a high risk of financial distress Conflict Between Debt and Equity: Illustrative Example • A firm owes its bondholders $120 next year. • This year’s earnings were less than expected, only $100. • The firm’s only assets are this cash and three potential investment projects. • All three projects produce cash flows next year when the debt is due. • The discount rate for all projects is 30%. Conflict Between Debt and Equity: Example, Part I Project Cashflow & Probability Riskiest Invest Bad Good E[CF] NPV Project 1: -100 110 50% 160 50% 135 3.8 Project 2: -100 50 80% 240 20% 88 -32.3 Project 3: -100 120 80% 130 20% 122 -6.2 Safest Rank Conflict Between Debt and Equity: Example, Part II Firm valuation Project Cashflow & Probability Invest Bad Good E[CF] NPV Rank Project 1: -100 110 50% 160 50% 135 3.8 1 Project 2: -100 50 80% 240 20% 88 -32.3 3 Project 3: -100 120 80% 130 20% 122 -6.2 2 Conflict Between Debt and Equity: Example, Part III Equity holder valuation Equityholder Cashflow & Probability Invest Bad Good E[CF] Rank Project 1: -100 0 50% 40 50% 20 2 Project 2: -100 0 80% 120 20% 24 1 Project 3: -100 0 80% 10 20% 2 3 Conflict Between Debt and Equity: Example, Part IV Debtholder valuation Debtholder Cashflow & Probability Invest Bad Good E[CF] Rank Project 1: -100 110 50% 120 50% 115 2 Project 2: -100 50 80% 120 20% 64 3 Project 3: -100 120 80% 120 20% 120 1 Conflicts Between Debt and Equity Investors From the example, we see that: • Debtholders prefer safer projects. • They have priority in cash flow • They only care about the first X dollars • Equity holders prefer risky projects. • They are a residual claimant with limited liability • Potentially unlimited upside • Due to the conflict of interest, no one has the incentive to pick the best project. In the example, if managers act in the interests of shareholders, they will pick Project 2 (NPV = −32!). • The negative effects can be big • This is a real cost of financial distress Conflicts Between Debt and Equity Investors (cont.) There are two well-known agency problems of debt: 1. Asset substitution/overinvestment/risk-shifting: When debt is in place, equity has the incentive to take excessive and inefficient risks. 2. Debt overhang/underinvestment: When debt is in place, equity has the incentive to refuse positive NPV projects. The End Risk-Shifting Intuition: Risk-Shifting Why do equity investors prefer more risk? • Levered equity: a call option on the firm’s assets • Exercise price: face value of debt • An option is more valuable if volatility/risk of the underlying (ie, the assets) increases Why are shareholders’ incentives to increase risk greater in financial distress? • Limited liability/downside risk • Win: shareholders reap most of the gains • Lose: debtholders suffer most of the losses Risk-Shifting: Example, Part I • Assume your company has $50 (face value) of debt maturing next year. • After poor performance, the market value of assets has dropped to $30, with the following cash flows in one year. • Assume zero interest/no discount. 60 (D: 50, E: 10) 0.5 30 0.5 0 (D: 0, E: 0) Risk-Shifting: Example, Part II • The firm is in financial distress: • Market value of assets is less than the face value of the debt • Market value balance sheet: Assets 30 Total assets 30 Debt Equity Total liabilities 25 5 30 • Why does equity have any value? • Recall levered equity is a call option on assets with strike price at face value • Even though it’s out of the money now, the option still has time value Risk-Shifting: Example, Part III • Suppose the assets can be alternatively used for another project with the following cash flows: 0.25 100 (D: 50, E: 50) 25 0.75 Assets 25 Total assets 25 (↓ by 5) 0 (D: 0, E: 0) Debt Equity Total liabilities 12.5 (↓ by 12.5) 12.5 (↑ by 7.5) 25 • Firm value falls but the value of equity increases! Shareholders are essentially gambling with debtholders’ money. The End Debt Overhang (and Other Games) Debt Overhang: Example, Part I • We will use the same set-up as the risk-shifting example. Your company has $50 (face value) of debt maturing next year. • Your assets will produce the following cash flows in one year. • Assume zero interest/no discount. 60 (D: 50, E: 10) 0.5 30 0.5 0 (D: 0, E: 0) Debt Overhang: Example, Part II • Suppose you can spend $9 to hire a better manager. This better manager can make the terminal cash flow $60 for sure. • The incremental cash flows to the firm from hiring this new manager are: 0.5 0.5 0 60 • Therefore, the incremental NPV of the new manager is −9 + 60 × 0.5 = 21 > 0. The firm should hire the manager. Debt Overhang: Example, Part III Will they? • If the new hire goes ahead, debtholders receive their face value ($50) with certainty, so a good deal for them! • Will equity holders agree to fund the hire (assume from existing assets)? The incremental cash flows to equity holders from the new hire are: 0.5 0 0.5 10 • NPV for equityholders is −9 + 0.5 × 10 = −4 < 0. Refuse! • Market value balance sheet if hire were to go ahead: Assets 51 Total assets 51 Debt Equity Total liabilities 50 (↑ by 25) 1 (↓ by 4) 51 Debt Overhang: Intuition • Positive NPV projects require inputs. • Equity pays the costs. • Improved cash flow largely goes to paying back debt. • Pay-off to debt increases. • Gross terminal pay-off to equity also increases, but net of the costs, it can decrease. • Equity pays the costs, but benefit accrues to debt. • As a result, some positive NPV projects are passed up. Other Games • Cash in and run • When default is likely, sell assets and pay out the proceeds as big dividends; the decline in market value is shared with creditors • Playing for time • Accounting manipulations to hide problems • Bait and switch • Issue bond, saying this is the most senior bond I will issue; subsequently renege and issue a more senior bond (ie, with higher priority) The End Trade-Off Theory CFD Summary • What are the costs of financial distress (CFD)? • Direct costs (lawyers’ fees, court fees) are small. • Indirect costs can be large and can arise before bankruptcy. • Indirect costs also vary across firms/industries and the type of company’s assets. • For example, they are much lower if assets are, for instance, real estate or tangible assets. They are higher if assets are intangible. • Industries in which firms can more easily increase risk (eg, growth firms) may face higher indirect costs from risk-shifting behaviour. So How Much Should a Firm Borrow? • Trade-off theory: The optimal leverage (amount of debt) should balance the benefits and costs of debt. • How do you quantify this trade-off? Use APV: VL = VU + PV(tax shields) − PV(costs of financial distress) where: VL : levered value of project/firm VU : all-equity value of project/firm PV(tax shields): value of all tax savings from debt PV(costs of financial distress): value of all direct and indirect costs of financial distress Present Value of CFD Inputs required are estimates of: • Probability of bankruptcy (p) • Use bond rating and empirical estimates of default probability for each rating • Costs of bankruptcy (CFD) • Empirical studies of direct (3% of book assets) and indirect costs (only qualitative studies; difficult to measure) • Bond expected return (rD ) A model of default: PV(CFD) = ∞ X t=1 p (1 − p)t−1 CFD pCFD = rD + p (1 + rD )t Trade-Off Theory Maximum value of firm Market value of the firm Costs of financial distress PV of interest tax shields Value of levered firm Value of unlevered firm Optimal amount of debt Debt 1 Source: Brealey, Myers, and Allen 1 Trade-Off Theory: High vs Low Distress Costs 2 2 Source: Berk and DeMarzo Trade-Off Theory in Real Life • Most companies have a target debt ratio, which is consistent with trade-off theory. • High-tech growth companies with risky assets normally use relatively little debt. • But, trade-off theory cannot explain: • Why some of the most profitable companies with large income tax bills thrive with little debt. • Why debt ratios have not increased since the time when corporate income tax rates were low. The End