Financial Distress, Managerial Incentives, and Default | Study notes Economics

Financial Distress, Managerial

Incentives, and Information

16.1: Default and Bankruptcy in a Perfect Market

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

If a firm has access to capital markets and can issue new securities at a fair price, then it need not

default as long as the market value of its assets exceeds its liabilities.

If a company fails, its investors are equally unhappy whether the firm is levered and declares

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

When a firm declares bankruptcy, the news often makes headlines. Much attention is paid to the firm’s

poor results and the loss to investors. But the decline in value is not caused by bankruptcy: The

decline is the same whether or not the firm has leverage. That is, if it fails, the company will

experience economic distress, which is a significant decline in the value of a firm’s assets, whether or

not it experiences financial distress due to leverage.

Bankruptcy and Capital Structure

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

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

because a 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, and a firm will have the same total value and will be able to raise the

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

16.2: The Costs of Bankruptcy and Financial Distress

With perfect capital markets, the risk 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

available to all investors. Is this description of bankruptcy realistic? No. Bankruptcy is rarely simple

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

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

direct and indirect costs on the firm and its investors, costs that the assumption of perfect capital

markets ignores.

The Bankruptcy Code

When a firm fails to make a required payment to debt holders, it is in default. Debt holders can then

take legal action against the firm to collect payment by seizing the firm’s assets. Because the assets of

the firm might be more valuable if kept together, creditors seizing assets in a piecemeal fashion might

destroy much of the remaining value of the firm.

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

the value of the assets is not needlessly destroyed. According to the provisions of the 1978 Bankruptcy

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

• In Chapter 7 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.

• In the more common form of bankruptcy for large corporations, Chapter 11 reorganization,

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 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.

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Financial Distress, Managerial

Incentives, and Information

16.1: Default and Bankruptcy in a Perfect Market

A firm that fails to make the required interest or principal payments on the debt is in default. 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. If a firm has access to capital markets and can issue new securities at a fair price, then it need not default as long as the market value of its assets exceeds its liabilities. If a company fails, its investors are equally unhappy whether the firm is levered and declares bankruptcy or whether it is unlevered and the share price declines. When a firm declares bankruptcy, the news often makes headlines. Much attention is paid to the firm’s poor results and the loss to investors. But the decline in value is not caused by bankruptcy: The decline is the same whether or not the firm has leverage. That is, if it fails, the company will experience economic distress , which is a significant decline in the value of a firm’s assets, whether or not it experiences financial distress due to leverage.

Bankruptcy and Capital Structure With perfect capital markets, Modigliani-Miller (MM) Proposition I applies: The total value to all investors does not depend on the firm’s capital structure. Investors as a group are not worse off because a 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, and a firm will have the same total value and will be able to raise the same amount initially from investors with either choice of capital structure.

16.2: The Costs of Bankruptcy and Financial Distress

With perfect capital markets, the risk 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 available to all investors. Is this description of bankruptcy realistic? No. Bankruptcy is rarely simple and straightforward— equity holders don’t just “hand the keys” to debt holders the moment the firm defaults on a debt payment. Rather, bankruptcy is a long and complicated process that imposes both direct and indirect costs on the firm and its investors, costs that the assumption of perfect capital markets ignores.

The Bankruptcy Code When a firm fails to make a required payment to debt holders, it is in default. Debt holders can then take legal action against the firm to collect payment by seizing the firm’s assets. Because the assets of the firm might be more valuable if kept together, creditors seizing assets in a piecemeal fashion might destroy much of the remaining value of the firm. The U.S. bankruptcy code was created to organize this process so that creditors are treated fairly and the value of the assets is not needlessly destroyed. According to the provisions of the 1978 Bankruptcy Reform Act, U.S. firms can file for two forms of bankruptcy protection:

In Chapter 7 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.
In the more common form of bankruptcy for large corporations, Chapter 11 reorganization , 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 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. In addition to the money spent by the firm, the creditors may incur costs during the bankruptcy process. To ensure that their rights and interests are respected, and to assist in valuing their claims in a proposed reorganization, creditors may seek separate legal representation and professional advice. When a financially distressed firm is successful at reorganizing outside of bankruptcy, it is called a workout. Another approach is a prepackaged bankruptcy (or “prepack”), in which a firm will first develop a reorganization plan with the agreement of its main creditors, and then 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 Aside from the direct legal and administrative costs of bankruptcy, many other indirect costs are associated with financial distress (whether or not the firm has formally filed for bankruptcy). While these costs are difficult to measure accurately, they are often much larger than the direct costs of bankruptcy.

Loss of customers: Because bankruptcy may enable or encourage firms to walk away from commitments to their customers, customers may be unwilling to purchase products whose value depends on future support or service from the firm.
(^) Loss of suppliers: Suppliers may also be unwilling to provide a firm with inventory if they fear they will not be paid. The bankruptcy filing itself can alleviate problems through 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: Knowing that the firm might go out of business or at least experience significant management turnover reduces the incentive of customers to maintain a reputation for timely payment.
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. To do so, the firm may accept a lower price than would be optimal if it were financially healthy.
Inefficient liquidation.
Cost to creditors: default of the firm may lead to costly financial distress for the creditor.

Because bankruptcy is a choice the firm’s investors and creditors make, there is a limit to the direct and indirect costs on them that result from the firm’s decision to go through the bankruptcy process. If these costs were too large, they could be largely avoided by negotiating a workout or doing a prepackaged bankruptcy. Thus, these costs should not exceed the cost of renegotiating with the firm’s creditors.

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. 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.

Financial Distress, Managerial Incentives, and Default, Study notes of Economics

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Financial Distress, Managerial

Incentives, and Information

16.1: Default and Bankruptcy in a Perfect Market

16.2: The Costs of Bankruptcy and Financial Distress