Ch16 Part A Financal Distress

5/11/2023
Financial Distress| Chapter 16 Prof. Nisan Langberg
Financial Distress (Part A)

Chapter 16
Default
Cost of Bankruptcy
Pricing Risky Debt with Bankruptcy costs
Conflicts of Interest and Leverage
Wrapping up
Default
Agenda for this Unit
What accounts as default?
Bankruptcy
Financial and Economic Distress
1
5/11/2023
Default
Rigidity of debt contracts Examples of Debt Covenants
Debt is backed by the company’s assets and Borrower must maintain “good standing” (pay taxes,
cash flows follow the law)
Default Borrower must maintain adequate insurance on all
assets that serve as collateral
When a firm misses an interest or principal
payment Borrower must maintain a debt to EBITDA ratio not
greater than 3x
Technical default
Upon default
When a firm on schedule with payments
Debtor can move courts to
but violates a condition of the debt contract
demand payment
(violates a covenant).
Bankruptcy Protection
Control by Shareholders Courts role
In normal times control of business decisions is Prevent the immediate transfer of control to
in the hands of equity holders through debtholders
management and board of directors
Allow management to maintain control over
Control by Debtholders firm recovery process
Once the firm misses a payment or violates Assign a trustee to monitor management and
a covenant control might transfer (with the make sure maximum payments to creditors are
help of courts) to debt holders made
Filing for Bankruptcy

Corporations can file for bankruptcy protection
(chapter 11) when anticipating possible default
4
2
5/11/2023
Common Reasons for Bankruptcy

Financial Planning Natural Disasters
Poor financial management might lead to a Natural disasters or Pandemics can disrupt a
mismatch of debt obligations and expenses company’s operations substantially
with the stream of cash flows
Management Economic Downturn

A poor management team will not fulfill the Weak macroeconomic conditions such as a
full earnings potential of the company recession
Industry Dynamics Increasing Borrowing Costs

Changes in the nature of competition, Rising interest rates
consumer tastes, new technology
5
Emerging from Bankruptcy

Survival The Optimal Outcome
The firm makes changes required and gets back Courts should aim towards the alternative that
on track to pay its debtors and continue maximizes Firm Value
operations
Acquisition
Firm is acquired or merged with existing But what alternative
firm and continues to operation under new maximizes firm value?
management
Liquidation
Firm ceases operations and its assets sold
3
5/11/2023
Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg
Continuation vs Liquidation Value

Continuation Value Recovery Strategy
This is the valuation of the firm if it continues A recovery strategy highlights the path for
operations. This value takes into account the recovery from financial distress and might
recovery strategy deployed including even include changes in the firm’s financial, strategic,
management shakeup. and management policies.
Liquidation Value Optimal Outcome

This is the value of the assets of the Continuing operation is desirable if:
company (real estate, machinery, patents) if
sold
Continuation Value >
Liquidation Value
Financial vs Economic Distress

Economic Distress
Economic conditions are such that the
present value of all future cash flows or
the continuation value is smaller than
the liquidation value
Does Economic Does financial
distress imply distress imply
Financial Distress financial distress? economic distress?
Capital structure is such that future
cash flows do not suffice to cover the
debt obligations, i.e., interest and/or
principal payments
4
5/11/2023
Four States of Economic/Financial Distress

Let’s match the The firm is worth more if liquidated but Financial Distress only
categories it can still pay its debt obligations
Economic Distress only
The firm is worth more if continues operations Not Distressed

but it cannot pay its debt obligations
Distressed Economically and
Financially
The firm is worth more if continues operations
and can pay its debt obligations
The firm is worth more if liquidated

and cannot pay its debt obligations
Financial Distress Costs

Efficient Market Benchmark
In efficient capital markets it is not
costly for firms to default on their debt
obligations.
What are the sources of

Bankruptcy costs bankruptcy cost?
In reality there are many reasons why

default imposes costs on firm both
directly and indirectly
10
5
5/11/2023
Costs of Bankruptcy
Direct Costs
Indirect Costs
Estimating Probability of Bankruptcy
Optimal Capital Structure Trade-off Theory
11
Direct Costs
Once in Bankruptcy
Throughout the bankruptcy process
several accountants, experts, advisors,
appraisers and lawyers are involved.
Fees
Fees to accountants, lawyers and other
advisors can add up to a substantial
burden on the firms during the years of
the bankruptcy process
12
6
5/11/2023
Direct Costs
A few more notable examples
United paid $8 million per month

in fees during 2003 - 2005
Lehman Brothers’ cost in fees of

over $7 Billion
Enron spent $30 million per month on legal

and accounting fees to exceed $750 million Now let’s turn to indirect costs
in total
13
Indirect Costs
A. Employee Retention
Employees value job security. With the
risk of looming layoffs talented workers
might leave.
Looking at a sample of Swedish companies,

authors find that firms lose workers as they
approach bankruptcy. Following a negative
export shock caused by exogenous currency
movements, talent abandons the firm, but only
if the exporter is highly leveraged. (JF 2021)
14
7
5/11/2023
Indirect Costs
B. Management Focus
Management needs to focus on surviving
bankruptcy which means less attention is
devoted to developing its business plan as
in normal times.
C. Costumers
Demand for products might decline
once customers believe there is a risk
that the company might not survive
bankruptcy.
On June 1, 2009 GM filed for bankruptcy in New York with $82

billion in assets and $173 billion in debt. Before filing for bankruptcy
GM suffered a slowdown in sales due to the recession years 2007 –
2009. CFO Ray Young highlights the challenge of leaving costumers.
15
Indirect Costs
D. Fire Sales
Firms are often pressured to “fire
sell” assets fast in bankruptcy. This
means a potential price discount and
loss to the firms.
Pulvino looks at secondary market transactions

for used commercial aircraft. He documented
that financially constrained airlines sold aircraft
at a 15% discount with larger discounts, 25-35%,
for airlines selling aircraft in US Chapter 7
procedures (JF 98).
Now let’s put it all together

16
8
5/11/2023
Putting it all Together

Estimating “cost of financial
distress”
Researchers used market price
information to back out the perceived
expected cost of bankruptcy.
Korteweg shows that empirically the average

expected overall direct and indirect bankruptcy
costs amount to 5% of firm value on average.
Once in bankruptcy it can rise to as high as 30%.
17
Market Measurement
Estimating “cost of financial
distress”
Recession years
Recession years
Recession years
The expected cost of bankruptcy

fluctuates over time.
Expected Cost of Financial

Distress (CFD)
𝐶𝐹𝐷 𝑞 $𝐵
Probability of Cost of bankruptcy

default once in default
18
9
5/11/2023
Likelihood of Default: Credit Rating

Likelihood of Default
Credit Rating Agencies provide market
estimates for the probability of default q
Expected Cost of Financial

Distress (CFD)
𝐶𝐹𝐷 𝒒 $𝐵

19
Determinants of CFD
Likelihood of Default q 𝐶𝐹𝐷 𝒒 $𝑩
Increasing in leverage
Increasing in variability/risk of earnings
Cost of Bankruptcy B
Varies across industries Would you expect the typical high-tech company to have
a higher or lower q than a typical real estate company?
Depends on asset redeployment – the
ability to transfer assets from one firm Would about B ?
to the other
20
10
5/11/2023
Optimal Capital Structure: Trade-Off Theory

Trade off theory
Firms optimally balance the tax advantage of Low B

debt and the expected cost of financial
distress.
𝑉 𝑉 𝑃𝑉 𝐼𝑇𝑆 𝑃𝑉 𝐶𝐹𝐷
High B
As leverage increases the ITS increases, the
likelihood of default q increases, and CFD increases
21
Pricing Risky Debt with Bankruptcy Costs
Armin Industries’ loan (no bankruptcy cost)
Armin Industries’ loan (with bankruptcy cost)
Armin Industries’ loan Summary
22
11
5/11/2023
Armin Industries
The Investment Opportunity
Armin Industries is an Illinois based manufacturer in the injection molding arena. Recently, its revenues
have fallen dramatically. David, Armin’s CEO is thinking of launching a new product this year that
requires an upfront investment of $85.7 million.
Post-Investment David estimates that the value of Armin be either $150

million (with 50% chance) or $80 million (with 50% chance). Assume that
Armin’s cash flows have a 𝛽 0 and 𝑟 5% . (disregard corporate taxes)
Spoiler…we will soon introduce bankruptcy costs

23
David approaches Pnina from Star Bank (Debt)

David’s email to Pnina Pnina’s reply How should David reply?
Dear Pnina, Dear David,

We at Armin Industries have been a client of Star I processed your loan application for $87.5 million. As
Bank for several years. We need a $85.7 million you mention yourself this is a risky loan. Given the
one year loan. I know it is a risky move for us but risk involved the bank can offer you the loan at
at this point we need to take bold actions in order interest of 26%. We require a repayment in one year
to succeed. Please let me know the bank’s terms. of P=$85.7(1.26)=$108 million.
Sincerely, Please confirm,
David Pnina
24
12
5/11/2023
David Analyzes Star Bank’s Offer $P=108

Let’s find the competitive debt payment
Time t=0 Time t=1
Pnina from Star Bank High Valuation of $150 million (prob. half)
Present Value of Payments to Bank: Armin’s payoff $150 – 108 = $42

Pnina’s payoff P=$108
0.5 $108 0.5 $80
𝐷
1.05
$94 Low Valuation of $80 million (prob. half)
$89.52
1.05
Armin’s payoff $0
So is this a good deal for David? Pnina’s payoff min(P,80)=$80
Why only $80 million payment?
$89.52 $85.7 No
25
Let’s look more closely at the return to

Competitive Debt Contract (finding P)
Star Bank
Time t=0 Time t=1
Present Value of Payments to Bank: Armin’s payoff $150 – P

Pnina’s payoff P
0.5 $𝑃 0.5 $80
𝐷 $85.7
1.05
Low Valuation of $80 million (prob. half)
⇒ 0.5 $𝑃 0.5 $80 $90
Armin’s payoff $0
⇒ $𝑃 $100 Pnina’s payoff min(P,80)=$80
Notice, the bank breaks even! Why only $80 million payment?
26
13
5/11/2023
Return to Star Bank under $P=100

Star Bank’s Expected Return is 5%
Loan Value Dynamics
The value of Debt at time t=0 :
𝐷 $85.7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
The value of Debt at time t=1:
𝑏𝑎𝑑 𝑠𝑡𝑎𝑡𝑒 𝐷 $80 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝐷 $100 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑔𝑜𝑜𝑑 𝑠𝑡𝑎𝑡𝑒
6.65% 0% 16.69% 27
David’s Reply to Pnina from Star Bank (Debt) How should David reply?
David’s email to Pnina Pnina’s reply

The way we see it, a 26% interest on the loan is We are well aware of Armin’s non-cyclical cash flows
quite aggressive given our payment estimates. A and beta of zero. But, you are ignoring the costs of
competitive offer should be around 16% interest or bankruptcy which will have an effect on the net value
payment of $P =$100. That will give Star 5% on of the firm if things go south on you. Believe me that
average – the risk free rate which is appropriate we know what bankruptcy means and a 10% CFD or
for our zero beta. Let me know what you think. a B=$80(10%)=$8 million is reasonable.
Sincerely, Please confirm,
David Pnina
28
14
5/11/2023
Lets continue with David’s

Pricing Risky Debt with Bankruptcy Costs reply to Star Bank
Pricing Risky Debt (efficient markets) Pricing Risky Debt with Bankruptcy costs
When pricing Risky debt we take into account the When default is costly we consider the debt
possibility of default, i.e., that CF < $P. payment net of the bankruptcy cost $B.
In efficient capital markets there are no costs In the state of default, i.e., when CF < $P, the
associated with default and in the state of default, payment to debt holders is now $CF - $B.
i.e., when CF < $P, the payment to debt holders is
min(CF,$P) = CF
This was David’s approach at first when

pricing the competitive contract at $P=100
29
David Analyzes the Deal $P=108 again

(now with bankruptcy cost)
Time t=0 Time t=1
Present Value of Payments to Bank: Armin’s payoff $150 – 108 = $42

Pnina’s payoff P=$108
0.5 $108 0.5 $𝟕𝟐 $90
𝐷 $85.7
1.05 1.05
Low Valuation of $80 million (prob. half)
So is this a good deal for David once bankruptcy Armin’s payoff $0
costs are incorporated? Bankruptcy cost $8 million
Pnina’s payoff min(P,80-8)=$72
YES Star breaks even!
Why only $72 million payment?
30
15
5/11/2023
Return to Star Bank when $P=108 (with bankruptcy cost)

Star Bank’s Expected Return is 5%
Loan Value Dynamics
The value of Debt at time t=0 :
𝐷 $85.7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
The value of Debt at time t=1:
𝑏𝑎𝑑 𝑠𝑡𝑎𝑡𝑒 𝐷 $72 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝐷 $108 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑔𝑜𝑜𝑑 𝑠𝑡𝑎𝑡𝑒
16% 0% 26% 31
David’s Reply to Pnina from Star Bank (Debt) What is the expected CFD at
time t=0
David’s email to Pnina Pnina’s reply
Point well taken! A 10% bankruptcy cost upon I am happy we see things the same way.
default is reasonable I agree – you have more I am looking forward to supporting Armin Industries
experience than me in estimating this. We will go with this important loan.
ahead with your offer of 26% interest or payment Sincerely,
of $P =$108. Our lawyers will be in touch soon. Pnina
Sincerely,
David
32
16
5/11/2023
Armin Industries – Summary

Cost of Financial Distress (t=1) Value of (hypothetical) Unlevered Armin
𝐶𝐹𝐷 𝑞 $𝐵 50% $8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

0.5 $150 0.5 $80
$4 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑉 $109.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1.05
Present Value of CFD Value of Levered Armin
$4 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑉 𝑉 𝑃𝑉 𝐼𝑇𝑆 𝑃𝑉 𝐶𝐹𝐷

𝑃𝑉 𝐶𝐹𝐷
1.05 109.5 0 3.8 $105.7 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
$3.8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
For simplicity we ignored the tax advantage of
debt here in this example
33
Conflicts of Interest Between Debtholders

and Equity holders
Debt, Equity and Cash Flow Rights
Shareholders’ appetite for Risk
34
17
5/11/2023
Debt, Equity and Cash Flow Rights

Normal Times Times of Financial Distress
When solvent (not in financial distress) debt These are times in which it becomes likely
payments are honored, shareholders control the that the firm will enter default and
firm, and enjoy any profits in access of debt debtholders might not receive their full
liabilities. interest and principal payments
Shareholders care about upside and downside Shareholders care mostly about upside potential.
value fluctuations They enjoy downside protection (limited liability)
Debtholders are indifferent to reductions in cash Debtholders bare the cost of lower cash flows.
flows as long as they paid interest and principal
Let’s see this graphically
35
Three States of Solvency

Normal Times
Value of the firm is substantially
Financial Distress above its debt obligation
Value of the firm is close to
its debt obligation. Control
is still in the hands of
shareholders but default
becomes an option
Default
Value of the firm is below its
debt obligation
18
5/11/2023
Three States of Solvency (Perspective of Debtholders)

Normal Times
above its debt obligation and
Financial Distress debt is paid in full
Value of the firm is close to
its debt obligation.
Default Debt holders do not share upside

Value of the firm is below its potential
debt obligation
Three States of Solvency (Perspective of Equityholders)

Normal Times
above its debt obligation
Financial Distress
Value of equity is close to
zero and the firm is close How does this affect
to default shareholders appetite for risk?
Default
Value of equity is zero Equity holders do not share
(downside protection) downside potential
19
5/11/2023
Appetite for Risk Taking (Normal Times)

In normal times shareholders bare the costs
Consider a risky strategy that can move the firm’s
and benefits of firm risk. They have the
value upwards to point H or downwards to point L
incentive to choose strategy risk to maximize
firm value
Shareholders benefit from the upward movement to H

and bare the cost from the downward movement to L
debtholders are indifferent between the

two risk outcomes and the statuesque
Appetite for Risk Taking (Financial Distress)

In times of financial distress shareholders do
Consider a risky strategy that can move the firm’s
not bare the full cost of downward movements
value upwards to point H or downwards to point L
in firm value and might take excessive risks
at the expense of debtholders.
debtholders do not benefit Shareholders benefit from the

from the upward movement upward movement to H and bare
to H but bare a cost due to the H
only part of the cost from the
downward movement to L downward movement to L
L
20
5/11/2023
In Part B of Chapter 16
Asset substitution problem: when Debt Overhang problem: when the debt
shareholders choose risky investments in burden of a firm is so large that management
order to increase the value of Equity at the finds it difficult to pursue new healthy
expense of the value of Debt (and sometimes investment opportunities.
at the expense of firm value).
We will learn to appreciate these problems and

identify solutions through different types of
debt restructurings.
41
Wrapping up
Economic and Financial Distress
Direct and Indirect Costs of Bankruptcy
Pricing Risky Debt with CFD
The three states of solvency: Debt and Equity Perspectives
Part B: Asset Substitution and debt overhang

problems and their solutions
42
21

Ch16 Part A Financal Distress

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Ch16 Part A Financal Distress

Uploaded by

Copyright:

Available Formats

5/11/2023

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial Distress (Part A)

Pricing Risky Debt with Bankruptcy costs

Conflicts of Interest and Leverage

Financial Distress| Chapter 16 Prof. Nisan Langberg

Agenda for this Unit

What accounts as default?

Financial and Economic Distress

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial Distress| Chapter 16 Prof. Nisan Langberg

Filing for Bankruptcy

Financial Distress| Chapter 16 Prof. Nisan Langberg

Common Reasons for Bankruptcy

Management Economic Downturn

Industry Dynamics Increasing Borrowing Costs

Financial Distress| Chapter 16 Prof. Nisan Langberg

Emerging from Bankruptcy

Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg

Continuation vs Liquidation Value

Liquidation Value Optimal Outcome

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial vs Economic Distress

Financial Distress| Chapter 16 Prof. Nisan Langberg

Four States of Economic/Financial Distress

The firm is worth more if continues operations Not Distressed

The firm is worth more if liquidated

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial Distress Costs

What are the sources of

In reality there are many reasons why

Financial Distress| Chapter 16 Prof. Nisan Langberg

Agenda for this Unit

Estimating Probability of Bankruptcy

Optimal Capital Structure Trade-off Theory

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial Distress| Chapter 16 Prof. Nisan Langberg

United paid $8 million per month

Lehman Brothers’ cost in fees of

Enron spent $30 million per month on legal

Financial Distress| Chapter 16 Prof. Nisan Langberg

Looking at a sample of Swedish companies,

Financial Distress| Chapter 16 Prof. Nisan Langberg

On June 1, 2009 GM filed for bankruptcy in New York with $82

Financial Distress| Chapter 16 Prof. Nisan Langberg

Pulvino looks at secondary market transactions

Now let’s put it all together

Financial Distress| Chapter 16 Prof. Nisan Langberg

Putting it all Together

Korteweg shows that empirically the average

Financial Distress| Chapter 16 Prof. Nisan Langberg

The expected cost of bankruptcy

Expected Cost of Financial

Probability of Cost of bankruptcy

Financial Distress| Chapter 16 Prof. Nisan Langberg

Likelihood of Default: Credit Rating

Expected Cost of Financial

Probability of Cost of bankruptcy

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial Distress| Chapter 16 Prof. Nisan Langberg

Optimal Capital Structure: Trade-Off Theory

Firms optimally balance the tax advantage of Low B

As leverage increases the ITS increases, the

likelihood of default q increases, and CFD increases