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Costs of Financial Distress and Strategies to Reduce Debt

This finance seminar covers the cost of financial distress, both direct and indirect, and explores strategies to reduce the burden of debt. Topics include the integration of tax benefits and financial distress costs, balance sheet for a company in distress, selfish strategies, protective covenants, reducing costs of debt, and the integration of tax effects and financial distress costs.

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Costs of Financial Distress and Strategies to Reduce Debt

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  1. Finane I November 23 QDai for FEUNL

  2. Topics covered • Cost of financial distress • Direct cost • Indirect cost • Reducing cost of debt • Integration of tax benefit and financial distress cost of debt QDai for FEUNL

  3. Last class • MM with corporate tax • Theoretical suggestion: • Practice in the real world: • Cost of debt: QDai for FEUNL

  4. Costs of financial distress • Direct costs: • Indirect costs: • Impaired ability to conduct business • Agency costs QDai for FEUNL

  5. Balance Sheet for a Company in Distress Assets BV MV Liabilities BV MV Cash LT bonds Fixed Asset Equity Total Total What happens if the firm is liquidated today? QDai for FEUNL

  6. Selfish Strategy 1: Take Large Risks The Gamble Probability Payoff Win Big 10% $1,000 Lose Big 90% $0 Cost of investment is $200 (all the firm’s cash) Required return is 50% Expected CF from the Gamble = QDai for FEUNL

  7. Selfish Stockholders Accept Negative NPV Project with Large Risks • Expected CF from the Gamble • To Bondholders = • To Stockholders = • PV of Bonds Without the Gamble • PV of Stocks Without the Gamble • PV of Bonds With the Gamble: • PV of Stocks With the Gamble: QDai for FEUNL

  8. Selfish Strategy 2: Underinvestment • Consider a government-sponsored project that guarantees $350 in one period • Cost of investment is $300 • the firm only has $200 now • the stockholders will have to supply an additional $100 to finance the project • Required return is 10% Should we accept or reject? QDai for FEUNL

  9. Selfish Strategy 2: Underinvestment QDai for FEUNL

  10. Selfish Strategy 3: Milking the Property • Liquidating dividends • Suppose our firm paid out a $200 dividend to the shareholders. This leaves the firm insolvent, with nothing for the bondholders, but plenty for the former shareholders. • Increase perquisites to shareholders and/or management QDai for FEUNL

  11. Protective Covenants • Negative covenant: • Positive covenant: QDai for FEUNL

  12. Reducing Costs of Debt • Debt Consolidation: QDai for FEUNL

  13. Integration of Tax Effectsand Financial Distress Costs • Trade-off between the tax advantage of debt and the costs of financial distress. QDai for FEUNL

  14. Integration of Tax Effectsand Financial Distress Costs Value of firm (V) Maximumfirm value 0 Debt (B) Optimal amount of debt B* QDai for FEUNL

  15. The Pie Model • VT = • Marketed claims: • Nonmarketed claims: QDai for FEUNL

  16. Signaling • The firm’s capital structure is optimized where • Investors view debt as QDai for FEUNL

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