Ch16 Part B Financal Distress

5/28/2023
Financial Distress| Chapter 16 Prof. Nisan Langberg
Financial Distress (Part B)

Chapter 16
Risk Shifting
Debt‐overhang
Other issues
Wrapping up
Risk Shifting
Agenda for this Unit
Debt concessions
Armin Industries strategy shift
Debt to Equity Swap
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Debt Concessions
Debt‐to‐Equity‐Swap
Debt holders following restructuring negotiations

discharge their debt claim in return for a conversion to
equity in the company.
Hair cut
Debt holders following restructuring negotiations
agree to lower than initially contracted interest or
principal payments on their debt.
Armin Industries – Developments

New Product Failure
Armin Industries funded the upfront investment of $85.7 million with debt from Star Bank
with payment due of P=$100 million. After investment took place it became clear to David,
the CEO of Armin, that the new product will unfortunately not deliver the desired outcome
in one year. The value of Armin is going to be $80 million unless David can do something
about it.
Strictly speaking is Armin
David called for a board meeting to already in default?
discuss the situation and further
actions
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Armin First Board Meeting

David The Board
Dear board members, David,
Unfortunately I inform you that the new product This is indeed an unfortunate turn of events. We are
we launched is not fulfilling its potential and as a sure you came here today with a suggestion of how
result we are heading toward an end of year to move forward. Remember, Armin did not miss a
payoff of $80 million. As you know this is below payment yet and you are still in control. Lets stay
our obligation of $100 million to our debt holders. optimistic.

What do you suggest?
Armin First Board Meeting

David The Board
Yes of course. My team and I are contemplating OK….sounds sufficiently interesting. Lets hear more
launching a strategy shift we have been thinking details.
about for a long time but it was never quite the Please get back to us with the numbers you see
right time. We will tap a an existing alternative going forward if Armin indeed shifts strategy in the
consumer base with our new product. It is a fast direction of this consumer base.
and hopefully successful fix. If it works…it will save

us…. but it has its risks as well.
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Armin Industries – Strategy Shift

David’s Proposal
The “Strategy Shift” David is considering can be immediately implemented and requires no upfront
investment. It’s risky though. It has a 50% chance of success. If it succeeds it will increase the payoff to
$120 million, but if it fails the payoff will be as low as $20 million.
David’s argument to the board… Does this create value to equity

holders?
Dear board members,
Don’t be discouraged by the text‐book negative NPV of this
strategy! I know, expected value will go down from $80 million to
$70 million. But, you need to remember that our responsibility is
to equity holders. 7
Evaluating the Strategy Shift

Statues quo
Status Quo (millions)
Assets $80 million
Debt $80 million
Equity $0
Strategy Shift
New Strategy (millions)
Success Failure Expected
Assets $120 $20 $70
Debt $100 $20 $60
Equity $20 $0 $10
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Armin Second Board Meeting

David The Board
David,
Dear board members,
We appreciate the initiative to promote shareholder
As you can see, from our estimates, the new
value. But, two things bother us:
strategy will give us a 50% chance to avoid
(1) This means 50% bankruptcy
bankruptcy and we’ll be able to offer a better
(2) …and a waist of resources (negative NPV initiative)
equity value to our trusting shareholders.
Talk to Star bank. Restructure debt so we can move on
I’m in favor!
with a higher value for shareholders and no bankruptcy.
Do I have your approval?
If they refuse the deal, go ahead with your strategy.
Debt Restructuring: Debt to Equity Swap Offer
David’s Proposal to Star Bank

David wants to avoid bankruptcy by offering a debt to equity swap. In exchange for giving up their debt,
StarBank will receive 80% equity ownership in Armin Inc. and the original shareholders will retain ownership of
the remaining 20%
Lets look at Star bank’s alternatives

What would you advise Star Bank to do?
Star bank should compare the expected value of 80% equity with the value of her existing debt claim
80% Equity Debt with P=$100
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Star Bank’s Perspective: Debt to Equity Swap Offer
Not Accepting: Accepting

In this case Star Bank keeps holding Armin becomes an all equity Status Quo
debt with payment due P=$100 million firm. David has no incentive to Assets $80 million
and it is optimal for David to go with take the strategy shift (why?). 80% Equity $64 million
the strategy shift (analyzed before) 20% Equity $16 million
Strategy Shift Star Bank benefits from accepting. Her gain is $4 million
Assets $70 million
Debt $60 million Lets look at Starbank’s alternatives
Equity $10 million
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Summary: Debt to Equity Swap Offer
80% Debt to Status quo Star Bank

Equity Swap retains P=$100
Strategy Chosen by David Status Quo Strategy Shift
Value to David 20% $80 = $16 0.5 ($20 + $0) = $10
Value to Star Bank 80% $80 = $64 0.5 ($100 + $20) = $60
Both David and Star Bank have the incentive

to push for the debt-to-equity swap deal
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Finding the Right Conversion Rate
q% Debt to Equity Swap Status quo Star Bank

retains P=$100
Strategy Chosen by David Status Quo Strategy Shift
Value to David (100‐q)% $80 0.5 $20 = $10
Value to Star Bank q% $80 0.5 ($100 + $20) = $60
Required so that Armin 100 𝑞 % $80 $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ⇒ 𝑞 87.5%

benefits
Required so that Star
𝑞% $80 $60 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ⇒ 𝑞 75%
Bank benefits 13
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Dealing with Risk Shifting
The Challenge Possible Remedy
• Once the firm is in financial distress, • Excessive risks mean an inefficient waste of
shareholders’ appetite for risk can increase due resources
to the asset substitution problem • There is an opportunity to create value for both
• If not dealt with, this might lead firms to debt and equity holders by restoring efficiency
undertake excessive risks (even in negative NPV • Since the problem stems from being in financial
projects) distress a solution can be to reduce leverage
• Such excessive risk can shift wealth from debt (such as by agreeing on a debt to equity swap)
holders to equity holders
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Debt‐Overhang
Debt concessions
Armin Industries strategy shift
Debt to Equity Swap
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Armin Industries – the Improvement Project

David’s alternative approach
Instead of going with the debt to equity swap that indeed keeps Armin afloat, David
decided to think more productively. Together with the CFO David put together a plan they
call the “Improvement Project” to improve the new product and fix its apparent
deficiencies. This allows partial recovery of losses and fast implementation.
The Improvement Project The only problem…
The improvement project requires an initial Armin does not have $20
investment of $20 million and will increase the payoff million to invest
from the current $80 million to $105 million.

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Why is this a problem?

Financing Positive NPV Projects
According to FINANCE 101 any positive NPV project should be executed, and if a firm does
not have the required funds then it can borrow from a bank or approach an equity investor.
What is different here in the case of Armin?
Can Armin raise new Can Armin raise new Lets try to address these
Debt to fund the $20 Equity to fund the $20 questions
million investment? million investment?
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Priority Matters
Debt‐Overhang
When a firm has prior obligations to existing debt holders any newly issued securities are
“junior” in their cash flow rights to these existing securities.
Managers of highly levered firms might find themselves unable to raise new capital to
jumpstart a recovery and grow out of financial distress.
Is raising new capital indeed impossible for Armin?
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5/28/2023
Raising New Capital‐ Impossible
New Equity?
Assets Liabilities
Debt =0
Once the project is Debt

Even 100% equity would
New Value $100 million
implemented the value of
$105 million not suffice to bring in new
Equity
Armin will increase to $105 $5 million equity capital
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Raising New Capital‐ Impossible
New (Junior) Debt?

Assets Liabilities
Debt =0
Once the project is Star Bank Debt

New debt holders will not
New Value $100 million
implemented the value of
$105 million find it optimal to provide a
New Debt
Armin will increase to $105 $5 million loan to Armin
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How then can Armin Finance the Improvement Project?

Restructuring existing debt
The only way to move forward is to reduce the pre‐existing debt burden.
David will ask for debt concession from existing debt holders
A tough spot for David
Can Armin negotiate concessions with existing The answer is YES…because the project
debt holders, raise sufficient new debt to fund is NPV positive!
the Improvement Project and increase value
Lets look into this more closely…
for existing share holders?
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David approaches Pnina from Star Bank

David’s email to Pnina Pnina’s reply
Dear Pnina, Dear David,

As you know we at Armin are in a tough spot and It is quite clear that Armin will not be able to pay the
are trying to figure out ways to improve our full amount of P = $100 million and this is
performance and grow and of course also pay our unfortunate. But, where did you get the number 18%
debt obligations. While you made it clear that Star from? How will this make things better for Star
Bank will not provide new capital I am asking that Bank? Sorry, unless you send some convincing
you accept a 18% haircut. numbers I cannot bring this to my supervisor.
Sincerely, sincerely,
David Pnina Where did David get 18% from?
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Explaining the Haircut amount of $X
With haircut of $X million Star Assets Liabilities

bank will receive $(100‐X)
Debt =0
million and Armin will have
Star Bank Debt
$(5+X) to pay new debt holders
New Value $100‐X million
$105 million New Debt

$5+X million Lets find X…
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With a 5% cost of capital (assuming we are still a year before the end of year payoff) the new debt
holders will demand payment of 𝑃 for the loan of $20 million.
𝑃
$20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ⇒ 𝑃 $21 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1.05
After payment of $ 100 𝑋 to debt holders Armin will have left $ 5 𝑋 to cover the payment to
the new debt holders 𝑃 so we require that,
$ 5 𝑋 𝑃 $21 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ⇒ 𝑋 $16 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
David (equity holders) receives But X cannot be too large…
$ 5 𝑋 21 $ 𝑋 16 0
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Star Bank: Has the alternative of not agreeing and receiving $80 million. Under the
restructuring plan Star Bank receives $(100‐X) which must be larger than $80.
$ 100 𝑋 $80 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ⇒ 𝑋 $20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Putting it all together:

$16 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑋 $20 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
Required so that Armin would have enough Required so that Star Bank would
free cash to repay new debt investors agree to the restructuring deal
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David approaches Pnina from Star Bank

David’s email to Pnina Pnina’s reply
Dear Pnina, Dear David,

As you can see from my explanation agreeing to Now that you spell it out this way I am convinced
the haircut deal will work to increase value for that concessions of a 18% haircut will actually
Star Bank! The benefit from the improvement increase the value of our debt position in Armin.
project in $4 million at the end of the year. I am I brought this to my supervisor and you have our
offering to split this between Armin and Star Bank. approval
Star Bank will benefit a $2million increase in value Good luck!
from $80 million to $82 million. Pnina
Sincerely,
David 26
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Debt and Incentives: Other Issues
Manager versus Shareholders
Shareholders versus Employees
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Discussion of Important Implications of Debt
Free Cash Flow Problem: Since CEO’s The Private Equity Model and Stronger Incentives: Private
hold a small fraction of firm equity (1% equity firms often increase leverage and the share of equity
of equity on average) they might choose ownership by executives to create stronger incentives for
strategies and projects that lead to value creation
waste of resources from the view of
shareholders (Pet‐Projects, Empire
Building). Debt obligations can help Management Bargaining: Managers are stronger
avoid wasteful behavior but might also negotiators with other stakeholders when they need to
reduce value enhancing investments. meet debt payments
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5/28/2023
Leverage, Firm Value, and Risk| Chapter 14 Prof. Nisan Langberg
Wrapping up
Conflicts of Interest between Debt and Equity holders
Risk shifting and Debt Overhang
Debt to equity swap
Debt concessions
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5/28/2023

Financial Distress| Chapter 16 Prof. Nisan Langberg

Financial Distress (Part B)

Financial Distress| Chapter 16 Prof. Nisan Langberg

Agenda for this Unit

Armin Industries strategy shift

Debt to Equity Swap

Financial Distress| Chapter 16 Prof. Nisan Langberg

Debt holders following restructuring negotiations

Financial Distress| Chapter 16 Prof. Nisan Langberg

Armin Industries – Developments

Financial Distress| Chapter 16 Prof. Nisan Langberg

Armin First Board Meeting

Dear board members, David,

our obligation of $100 million to our debt holders. optimistic.

Financial Distress| Chapter 16 Prof. Nisan Langberg

Armin First Board Meeting

launching a strategy shift we have been thinking details.

and hopefully successful fix. If it works…it will save

Financial Distress| Chapter 16 Prof. Nisan Langberg

Armin Industries – Strategy Shift

David’s argument to the board… Does this create value to equity

Don’t be discouraged by the text‐book negative NPV of this

strategy! I know, expected value will go down from $80 million to

$70 million. But, you need to remember that our responsibility is

Financial Distress| Chapter 16 Prof. Nisan Langberg

Evaluating the Strategy Shift

Financial Distress| Chapter 16 Prof. Nisan Langberg

Armin Second Board Meeting

Financial Distress| Chapter 16 Prof. Nisan Langberg

Debt Restructuring: Debt to Equity Swap Offer

David’s Proposal to Star Bank

Lets look at Star bank’s alternatives

80% Equity Debt with P=$100

Financial Distress| Chapter 16 Prof. Nisan Langberg

Star Bank’s Perspective: Debt to Equity Swap Offer

Not Accepting: Accepting

Financial Distress| Chapter 16 Prof. Nisan Langberg

Summary: Debt to Equity Swap Offer

80% Debt to Status quo Star Bank

Strategy Chosen by David Status Quo Strategy Shift

Value to David 20% $80 = $16 0.5 ($20 + $0) = $10

Both David and Star Bank have the incentive

Financial Distress| Chapter 16 Prof. Nisan Langberg

Finding the Right Conversion Rate

q% Debt to Equity Swap Status quo Star Bank

Strategy Chosen by David Status Quo Strategy Shift

Value to David (100‐q)% $80 0.5 $20 = $10

Value to Star Bank q% $80 0.5 ($100 + $20) = $60

Required so that Armin 100 𝑞 % $80 $10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ⇒ 𝑞 87.5%

Financial Distress| Chapter 16 Prof. Nisan Langberg

Dealing with Risk Shifting

The Challenge Possible Remedy

Financial Distress| Chapter 16 Prof. Nisan Langberg

Agenda for this Unit

Armin Industries strategy shift

Debt to Equity Swap

Financial Distress| Chapter 16 Prof. Nisan Langberg

Armin Industries – the Improvement Project

deficiencies. This allows partial recovery of losses and fast implementation.

The Improvement Project The only problem…

from the current $80 million to $105 million.

Financial Distress| Chapter 16 Prof. Nisan Langberg

Why is this a problem?