Lectures Notes Finance first semester, Study notes of Economics

Download Lectures Notes Finance first semester and more Study notes Economics in PDF only on Docsity! 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.