Corporate Finance

CHAPTER 16 - FINANCIAL DISTRESS, MAN. INCENTIVES AND INFORMATION

financial distress.

When a firm has trouble meeting its debt obligations we say the firm is in

16.1 Default and bankruptcy in a perfect market default.

A firm that fails to make the required interest or principal payments on the debt is in After the

firm defaults, debt holders are given certain rights to the assets of the firm. In the extreme case, the

debt holders take legal ownership of the firm’s assets through a process called bankruptcy. Recall that

equity financing does not carry this risk. While equity holders hope to receive dividends, the firm is

not legally obligated to pay them.

Thus, it seems that an important consequence of leverage is the risk of bankruptcy. Does this risk

represent a disadvantage to using debt? Not necessarily. As we pointed out in Chapter 14, Modigliani

and Miller’s results continue to hold in a perfect market even when debt is risky and the firm may

default. Let’s review that result by considering a hypothetical example.

Armin Industries: Leverage and the Risk of Default

Armin’s managers hope that a new product in the company’s pipeline will restore its fortunes. While

the new product represents a significant advance over Armin’s competitors’ products, whether that

product will be a hit with consumers remains uncertain. 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.

a)Scenario 1: New product succeeds. If the new product is successful, Armin is worth $150 million.

Without leverage, equity holders own the full amount. With leverage, Armin must make the $100

million debt payment, and Armin’s equity holders will own the remaining $50 million.

But what if Armin does not have $100 million in cash available at the end of the year? Although its

future

assets will be worth $150 million, much of that value may come from anticipated profits from

the new product, rather than cash in the bank. In that case, if Armin has debt, will it be forced to

default?

With perfect capital markets, the answer is no. As long as the value of the firm’s assets exceeds its

liabilities, Armin will be able to repay the loan. Even if it does not have the cash immediately

available, it can raise the cash by obtaining a new loan or by issuing new shares.

For example, suppose Armin currently has 10 million shares outstanding. Because the value of its

equity is $50 million, these shares are worth $5 per share. At this price, Armin can raise $100 million

by issuing 20 million new shares and use the proceeds to pay off the debt. After the debt is repaid, the

firm’s equity is worth $150 million. Because there is now a total of 30 million shares, the share price

remains $5 per share.

This scenario shows that if a firm has access to capital markets and can issue new securities at a fair

then it need not default as long as the market value of its assets exceeds its liabilities.

price, That is,

whether default occurs depends on the relative values of the firm’s assets and liabilities, not on its

cash flows. Many firms experience years of negative cash flows yet remain solvent.

b)Scenario 2: New product fails. 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 mil- lion debt payment and will have no

choice except to default. In bankruptcy, debt holders will receive legal ownership of the firm’s assets,

leaving Armin’s shareholders with nothing. Because the assets the debt holders receive have a value

of $80 million, they will suffer a loss of $20 million relative to the $100 million they were owed.

Equity holders in a corporation have limited liability, so the debt holders cannot sue Armin’s

shareholders for this $20 million—they must accept the loss.

Comparing the two scenarios. Both debt and equity holders are worse off if the product fails rather

than succeeds. Without leverage, if the product fails equity holders lose $150 million - $80 million =

but

$70 million. With leverage, equity holders lose $50 mil- lion, and debt holders lose $20 million,

the total loss is the same—$70 if the new product fails, Armin’s investors are equally

million. Overall,

unhappy whether the firm is levered and declares bankruptcy or whether it is unlevered and the share

price declines. if the new product fails, Armin’s investors are equally unhappy whether the firm is levered and

1

declares bankruptcy or whether it is unlevered and the share price declines.

TABLE 16.1 Value of Debt and Equity with and without Leverage

(in $ million)

Without Leverage With Leverage

Success Failure Success Failure

Debt value — — 100 80

Equity value 150 80 50 0

Total to all investors 150 80 150 80

This point is important. When a firm declares bankruptcy, the news often makes

This point is important. When a firm declares bankruptcy, the news often makes headlines. Much

headlines. Much attention is paid to the firm’s poor results and the loss to investors. But

attention is paid to the firm’s poor results and the loss to investors. But the decline in value is not

the decline in value is not caused by bankruptcy: The decline is the same whether or not

economic

the firm has leverage. That is, if the new product fails, Armin will experience

caused by bankruptcy: The decline is the same whether or not the firm has leverage. That is, if the

distress, which is a significant decline in the value of a firm’s assets, whether or not it expe-

new product fails, Armin will experience economic distress, which is a significant decline in the

riences financial distress due to leverage.

value of a firm’s assets, whether or not it experiences financial distress due to leverage.

542 Financial Distress, Managerial Incentives, and Information

Chapter 16 Bankruptcy and Capital Structure

Bankruptcy and Capital Structure

With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total value to all

With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total

a firm having leverage, bankruptcy alone does not lead to a greater reduction in the total

not

investors does not depend on the firm’s capital structure. Investors as a group are worse off

value to all investors does not depend on the firm’s capital structure. Investors as a group

value to investors. Thus, there is no disadvantage to debt financing, and a firm will have

are not worse off because a firm has leverage. While it is true that bankruptcy results from

because a firm has leverage. While it is true that bankruptcy results from a firm having leverage,

the same total value and will be able to raise the same amount initially from investors with

bankruptcy alone does not lead to a greater reduction in the total value to investors. Thus, there is no

either choice of capital structure.

1 There is a temptation to look only at shareholders and to say they are worse off when Armin has leverage

disadvantage to debt financing, and a firm will have the same total value and will be able to raise the

because their shares are worthless. In fact, shareholders lose $50 million relative to success when the firm

same amount initially from investors with either choice of capital structure.

EXAMPLE 16.1 Bankruptcy Risk and Firm Value

is levered, versus $70 million without leverage. What really matters is the total value to all investors, which

will determine the total amount of capital the firm can raise initially.

Problem

Suppose the risk-free rate is 5%, and Armin’s new product is equally likely to succeed or to fail.

For simplicity, suppose that Armin’s cash flows are unrelated to the state of the economy (i.e., the

risk is diversifiable), so that the project has a beta of 0 and the cost of capital is the risk-free rate.

Compute the value of Armin’s securities at the beginning of the year with and without leverage,

and show that MM Proposition I holds.

Solution

Without leverage, the equity is worth either $150 million or $80 million at year-end. Because

the risk is diversifiable, no risk premium is necessary and we can discount the expected value of

2

the firm at the risk-free rate to determine its value without leverage at the start of the year:

1 12

+

(150) (80)

2

U

= = =

Equity (unlevered) V $109.52 million

1.05

With leverage, equity holders receive $50 million or nothing, and debt holders receive $100

million or $80 million. Thus, 1 12

+

(50) (0)

2

= =

Equity (levered) $23.81 million

1.05

1 12

+

(100) (80)

2 =

= $85.71 million

Debt 1.05

L + +

= = =

Therefore, the value of the levered firm is V E D 23.81 85.71 $109.52 million.

With or without leverage, the total value of the securities is the same, verifying MM Proposition I.

The firm is able to raise the same amount from investors using either capital structure.

CONCEPT CHECK With perfect capital markets, does the possibility of bankruptcy put debt financing

1. at a disadvantage?

16.2 The costs of Bankruptcy and Financial Distress

Does the risk of default reduce the value of the firm?

2. risk

With perfect capital markets, the of bankruptcy is not a disadvantage of debt— bankruptcy simply

shifts the ownership of the firm from equity holders to debt holders without changing the total value

16.2 The Costs of Bankruptcy and Financial Distress

available to all investors.

Is this description of bankruptcy realistic? No. Bankruptcy is rarely simple and straight- forward—

With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt—

equity holders don’t just “hand the keys” to debt holders the moment the firm defaults on a debt

bankruptcy simply shifts the ownership of the firm from equity holders to debt holders

payment. Rather, bankruptcy is a long and complicated process that imposes both direct and indirect

without changing the total value available to all investors.

costs on the firm and its investors, costs that the assumption of perfect capital markets ignores.

Is this description of bankruptcy realistic? No. Bankruptcy is rarely simple and straight-

The Bankruptcy Code

forward—equity holders don’t just “hand the keys” to debt holders the moment the firm

The U.S. bankruptcy code was created to organize this process so that creditors are treated fairly and

defaults on a debt payment. Rather, bankruptcy is a long and complicated process that

the value of the assets is not needlessly destroyed. According to the provi- sions of the 1978

imposes both direct and indirect costs on the firm and its investors, costs that the assump-

tion of perfect capital markets ignores.

2 If the risk were not diversifiable and a risk premium were needed, the calculations here would become

more complicated but the conclusion would not change.

Bankruptcy Reform Act, U.S. firms can file for two forms of bankruptcy protection: Chapter 7 or

Chapter 11.

Chapter 7 liquidation,

In 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. Chapter 11 reorganization,

In the more common form of bankruptcy for large corporations, all

pending collection attempts are 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. 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. If an acceptable plan is not

put forth, the court may ultimately force a Chapter 7 liquidation of the firm.

Direct costs of Bankruptcy

The bankruptcy code is designed to provide an orderly process for settling a firm’s debts. However,

the process is still complex, time-consuming, and costly. 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. Investment

bankers may also assist with a potential financial restructuring.

Whether paid by the firm or its creditors, these direct costs of bankruptcy reduce the value of the

assets that the firm’s investors will ultimately receive. In some cases, such as Enron, reorganization

costs may approach 10% of the value of the assets. Studies typically report that the average direct

costs of bankruptcy are approximately 3% to 4% of the pre- bankruptcy market value of total assets.

Given the substantial legal and other direct costs of bankruptcy, firms in financial dis- tress can avoid

filing for bankruptcy by first negotiating directly with creditors. When a financially distressed firm is

workout.

successful at reorganizing outside of bankruptcy, it is called a Consequently, the direct costs

of bankruptcy should not substantially exceed the cost of a workout. Another approach is a

first

prepackaged bankruptcy (or “prepack”), in which a firm will develop a reorganization plan with

then

the agreement of its main creditors, and file Chapter 11 to implement the plan (and pressure any

creditors who attempt to hold out for better terms). With a prepack, the firm emerges from bankruptcy

quickly and with minimal direct costs.

Indirect Costs of Financial Distress

In total, the indirect costs of financial distress can be substantial. When estimating them, however, we

must remember two important points. First, we need to identify losses to total firm value (and not

solely losses to equity holders or debt holders, or transfers between them). Second, we need to

identify the incremental losses that are associated with financial distress, above and beyond any

losses that would occur due to the firm’s economic distress. A study of highly levered firms by Gregor

Andrade and Steven Kaplan estimated a potential loss due to financial distress of 10% to 20% of firm

value.

16.3 Financial Distress Costs and Firm Value

The costs of financial distress described in the previous section represent an important departure from

Modigliani and Miller’s assumption of perfect capital markets. MM assumed that the cash flows of a

firm’s assets do not depend on its choice of capital structure. As we have discussed, however, levered

firms risk incurring financial distress costs that reduce the cash flows available to investors.

Armin Industries:The Impact of Financial Distress Costs

To illustrate how these financial distress costs affect firm value, consider again the example of Armin

Industries. 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. In contrast, 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. We show the impact of these costs in Table 16.2, where we assume debt holders receive

only $60 million after account- ing for the costs of financial distress.

departure from Modigliani and Miller’s assumption of perfect capital markets. MM

549

assumed that the cash flows of a firm’s assets do not depend on its choice of capital struc-

16.3 Financial Distress Costs and Firm Value

ture. As we have discussed, however, levered firms risk incurring financial distress costs that

reduce the cash flows available to investors.

TABLE 16.2 Value of Debt and Equity with and without Leverage

(in $ million)

Armin Industries: The Impact of Financial Distress Costs

To illustrate how these financial distress costs affect firm value, consider again the example

Without Leverage With Leverage

of Armin Industries. With all-equity financing, Armin’s assets will be worth $150 million

Success Failure Success Failure

if its new product succeeds and $80 million if the new product fails. In contrast, with debt

Debt value — — 100 60

of $100 million, Armin will be forced into bankruptcy if the new product fails. In this case,

Equity value 150 80 50 0

some of the value of Armin’s assets will be lost to bankruptcy and financial distress costs.

Total to all investors 150 80 150 60

As a result, debt holders will receive less than $80 million. We show the impact of these

costs in Table 16.2, where we assume debt holders receive only $60 million after account-

ing for the costs of financial distress.

from the shareholders’ perspective. Why should equity holders care about costs borne by

As Table 16.2 shows, the total value to all investors is now less with leverage than it is

As Table 16.2 shows, the total value to all investors is now less with leverage than it is without

debt holders? -

without leverage when the new product fails. The difference of $80 million $60 million

leverage when the new product fails. The difference of $80 million - $60 million = $20 million is due

It is true that after a firm is in bankruptcy, equity holders care little about bankruptcy

= $20 million is due to financial distress costs. These costs will lower the total value of the

to financial distress costs. These costs will lower the total value of the firm with leverage, and MM’s

costs. But debt holders are not foolish—they recognize that when the firm defaults, they

firm with leverage, and MM’s Proposition I will no longer hold, as