Financial Distress EC 1745. Borja Larrain

Financial Distress EC 1745 Borja Larrain

Today: 1. Costs of financial distress. 2. Trade-off theory of capital structure. 3. Empirical estimates of the costs of financial distress. 4. Bankruptcy. Readings: Chapter 18 Welch

In this class: What if defaulting on your debt is not costless? Is capital structure irrelevant? How big are the costs of financial distress? Is financial distress the same thing as economic distress? Is a "liquidity problem" the same thing as a "solvency problem"? Are these two things easy to distinguish in practice? What does bankruptcy imply for a company?

1 Costs of Financial Distress (FD) Financial distress means a company is in trouble with creditors (e.g., the company missed an interest payment). It does not necessarily mean the projects of the firm are worthless. It could just be a "cash flow" situation. Remember: cash flows can vary a lot from year to year; interest or bond coupons don t. Probably running into a situation like this is not costless: a slice of the pizza is "lost", i.e., it does not end up in the hands of debtholders or shareholders. Example: A firm has cash flows tomorrow of $150 (good state) or $50 (bad state) with probability 50% each. It has debt that promises to pay $80 next year. If there is default, lawyers charge a $5 fee. The cash flows to investors are:

w/o cost of FD w/ cost of FD Debt Equity Debt Equity Lawyers Good 80 70 80 70 0 Bad 50 0 45 0 5 So far we have assumed in this class that we are in a situation without costs of financial distress, so debtholders get the entire cash flow if there is default. This is the Modigliani & Miller benchmark with perfect capital markets. Inthecasewithcostsofdistress,thesizeofthepizza is reduced. Default introduces a wedge between the cash flows of the firm and the cash flows distributed to investors. Costs of financial distress are a transaction cost if you want to think of it as one of the frictions that break perfect markets.

Two very important things: What breaks the M&M theorem is the presence of costs of default, not the event of default by itself. The probability of default can be positive, but default may not imply a cost (see the example above). Financial distress is not the same thing as economic distress: economic distress means the value of the projects of the firm has decreased. By "value of the projects" think of the value of the projectsasiffinanced 100% with equity. Is it easy to distinguish financial distress from economic distress? Of course not, often these two are related. Did the firm miss a debt payment because cash flows are temporarily lower (a "liquidity problem")or because cashflows are permanently lower (a "solvency problem")?

Are the problems short-lived or the whole industry is permanently less profitable than what we thought it was? (E.g., tobacco, American carmakers). What are the costs of financial distress? Direct: bankruptcycosts,i.e.,legalfees,etc. Indirect: value of the business that is destroyed because of the presence of debt that would not be destroyed if the firm did not have debt. E.g.: Underinvestment: pass up valuable projects because of the inability to raise new funds. Product-market issues: lost clients or lost marketshare because of lower quality of product, less advertisement, cut-backs in distribution efforts. Competitors may take this opportunity to be aggressive (e.g., cut prices) Internal to the firm: good employees leave.

2 Trade-off theory of capital structure This theory proposes that firms balance the taxadvantage of debt with the costs of financial distress to find their optimal leverage. We can think there is a certain cost function of financial distress (in present value) that is positively related with the level of debt: Q(D + ) The value of the firm is therefore: V L = V U + PV(tax shelter) Q(D) The conclusion, with corporate taxes only, was that the optimal capital structure is 100% leverage. Now the optimal leverage is below 100% depending on the costs of financial distress.

The Trade-Off Model of Capital Structure Firm value V L with tax shields, but no distress V L with tax shields and distress V U V L according to MM Leverage Optimal capital structure

One of the main implications of the trade-off theory is that a firm should revert towards a target leverage ratio when shocks move the firm from it. Do CFOs behave like this?

218 J.R. Graham, C.R. Harvey / Journal of Financial Economics 60 (2001) 187}243 Fig. 6. Survey evidence on whether "rms have optimal or target debt}equity ratios. The survey is based on the responses of 392 CFOs.

3 Empirical estimates of the costs of financial distress Weiss (Journal of Financial Economics, 1990) estimates direct bankruptcy costs: NYSE-AMEX firms that go bankrupt between 1979-1986: 37 firms Measures direct costs as a fraction of: Market value of equity = 16.7% Book value of debt plus market value of equity =2.6% Book value of total assets = 2.5% Indirect costs are much more difficult to measure.

It is hard to distinguish whether poor performance is caused by financial distress or economic distress (i.e., factors that pushed firms into distress in the first place). Andrade and Kaplan (1998) isolate firms that are purely financially distressed. Sample: start with 138 highly leveraged transactions (HLTs); transaction value exceeds $90 million. Select those HLTs that experience financial distress: Default or restructure debt after difficulty in making payments. Total of 31 firms (23 defaults, 8 restructure) A&K successfully isolate firms that are financially distressed, but not economically distressed:

Indeed highly leveraged: EBITDA/Interest = 0.97. But EBITDA/Sales = 9.8% > industry average. Therefore, distress is completely a result of leverage: with median industry leverage firms would have a coverage ratio of 3.9. Cost of financial distress. Compare value at resolution to value at distress onset. Value before distress is the value of capital at the end of year before distress. Value at resolution: sum of value at resolution and interim cash flows from end of year before distress to resolution. Results (Industry adjusted): Average cost of distress: 9.7% of pre-distress value.

Median cost of distress 20.7% of pre-distress value. Indirect costs are high relative to direct costs (3% at the most as estimated by Weiss (1990)). In addition to quantitative analysis, A&K perform a qualitative analysis. They identify evidence consistent with some cost of financial distress: Underinvestment: Unexpected cuts in capital expenditures. Undesired asset sales. No evidence of risk shifting/asset substitution (see next class on this point). The magnitude of indirect costs of FD is between 10% and 20% of value, but what about expected costs of distress? Back of the envelope calculation:

Cost of financial distress = 20%. Probability of financial distress < 33% for this sample of HLT. E(cost of FD) < 6.6%. This is a very selected sample; hard to extrapolate to "normal" firms. E(cost of FD) is probably much lower for typical public company. So, if expected costs are so low, why aren t public companies taking on more debt? Are there other costs associated with debt or advantages associated with equity? More on this next class.

4 Bankruptcy Bankruptcy can be initiated by creditors or debtors. In general, bankruptcy law can favor the debtor or the creditor: Give the debtor (manager) another chance to save the company, or Get the debtor away from the assets ASAP and let the creditor recover as much and as quickly as possible. The tradeoff is between reorganize or liquidate: max[v,l], where V is the value of the company as a "going concern" and L is the value of the assets if liquidated. If V > L it is better to reorganize. If V < L it is better to liquidate.

Key problem that courts face: how to measure V and L. The U.S. has a long history of debtor-friendly bankruptcy law: "If we have now to pay off our debts to British creditors, why did we fight the revolution?" (George Mason, US Patriot) 4.1 Chapter 11 Chapter 11 of US Bankruptcy Reform Act of 1978. The creditors are ordered to lay off while the debtor puts together a reorganization plan. No real equivalent to this in many other countries though superficially similar laws exist.

Problems: Incompetent debtors get time to screw things up even more. The reorganization plan may be unfair to creditors. Chapter 11 principal features: Automatic stay of all creditors prevents a rush to foreclose ahead of the other creditors. Debtor in Possession Financing allows new debt to come in senior to all in place before the filling. The management typically has the exclusive right to propose reorganization plans for the first 120 days of the bankruptcy. Voting to approve plan: classes of lenders that make no concessions and lose no priority or collateral are not able to vote.

Lenders do not accrue interest during bankruptcy this provides them with an incentive to settle quickly. More problems: The 120 days exclusivity period usually gets repeatedly extended, 2/3 of cases take 2 to 3 years. Reward for bad management? E.g.: 12 years Sign of the Dove Restaurant (Manhattan). 7 years LTV Steel. 6 years Wheeling Pittsburgh Steel. While in Chapter 11, Eastern Airlines and Pan Am could undercut their rivals because they had no interest costs. Judges can allow the debtor to borrow more money and give new creditors priority over old ones.

Legal and administrative costs on average 3% of assets. 4.2 Chapter 7 A chapter 7 bankruptcy is the process of liquidating a company and distributing any available assets to the company s creditors. The bankruptcy can be voluntary or involuntary. A trustee administers the sale and distribution of the assets. The trustee is paid in proportion ( 3%) to the asset proceeds eventually distributed. Distribution of proceeds based on priority. Secured creditors are being paid first. Priority list in Chapter 7:

1. Debt incurred post-bankruptcy. 2. Bankruptcy lawyers/trustees fees. 3. Various payments to the government, including taxes, social security payment, etc. 4. Secured creditors. 5. Unsecured creditors. 6. Preferred stockholders. 7. Common stockholders. Liquidation Pros:

Process is faster. Using cash auction to maximize the value of the proceeds. Serves as a warning to managers. Good for cases of economic distress. Liquidation Cons: Processistoofast. Subject to market conditions, industry/macro shocks. Hurt management incentives to take some risks. Bad for cases of pure financial distress.

4.3 Restructuring Debt Outside Bankruptcy In general, public bondholders cannot make informed concessions outside bankruptcy (coordination, information, free-riding etc.) Private placement debt and bank loans with a single (or few) lenders would avoid this problem. The bargaining between the lender(s) and the debtor depends on the outside option each one has (i.e. the liquidation value and the costs of financial distress). Example (Benmelech and Bergman 2008): On January 2001 AA bought the assets (aircrafts and gates) of bankrupt TWA. AA negotiated the terms of the leases with the lessors threatening to return the aircrafts (over 170 aircrafts at once). Those airplanes would have to be sold at "fire sale"prices. AA threat was credible and was able to cut the terms of the leases.