B5 Bankruptcy cost Flashcards

1
Q

Definition Financial Distress

A

A firm has difficulty meeting its debt obligations

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2
Q

Definition Default

A

A firm fails to make the required interest or principal payments on its debt, or violates a debt covenant.

After a default, debt holders are given certain rights to assets or even ownership through bankruptcy.

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3
Q

The financial distress process

A
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4
Q

Absolute Priority Rule (APR)

A

When firms are liquidated, the parties involved are served in the following order:

  1. Secured creditors, with claim of particular assets (or their values)
  2. Administrative expenses of the bankruptcy process
  3. Claims with statutory priority (tax claims, unpaid wages, etc.)
  4. Unsecured creditors’ claims (trade credit, damage claims, long-term bonds)
  5. Equity (shareholder, owner)
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5
Q

Two basic priority principles

A

Me first
All creditors are unsecured, no claims have statutory priority.
Creditors are ranked in order of date loans, earliest claims ranked highest. At last, what remains goes to equity holders

Last lender first
Creditors are ranked in order of date loans in reversed order: Latest claims are ranked highest.

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6
Q

Bankruptcy Code US vs Germany

A

US Ch 11 is a soft procedure:
(1) No filing reason is required,
(2) shareholders remain in charge,
(3) automatic stay on all creditor claims,
=> often a violation of APR

GER:
(1) firms must be insolvent and/or over indebted to file for bankruptcy.
(2) In nearly all cases, an administrator designated by the creditors takes over control,
(3) automatic stay on creditor claims of only 3 months, during which shareholders can propose a reorganization plan,
=> rarely a violation of APR

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7
Q

Direct costs of distress (3 bullet points) and estimation

A

Bankruptcy process is complex, time-consuming and costly:

(1) costly outside experts are hired
(2) creditors also incur costs through waiting several years to receive payments and may hire experts on their own
(3) smaller companies have relatively larger costs than large firms through significant direct legal costs

Estimates of total direct costs: < 5% of total assets

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8
Q

Indirect costs of distress (7) and comparison to direct costs

A
  1. Loss of Customers
  2. Loss of Suppliers
  3. Loss of Employees
  4. Loss of Receivables
  5. Fire Sale of Assets
  6. Delayed Liquidation
  7. Costs to Creditors

=> Hard to measure accurately, estimated much larger than direct costs

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9
Q

What are Fire Sales?

A

Definition: .. a forced sale of an asset at a dislocated price

  • *forced:** in the sense that the seller cannot pay creditors without selling assets.
  • *dislocated price:** high potential bidders are typically involved in similar activity. They may be financially constrained, too.
  • *=>** Therefore, assets are bought by non-experts who are only willing to buy at lower prices.
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10
Q

Who bears the cost of bankruptcy (direct/indirect)?

A

(1) The loss to shareholders is limited to their original investment.
(2) If the value of the firm’s assets is below the repayment value of debt, the difference is borne by debt holders.

But: Ex ante, if securities are fairly priced, the shareholders pay the present value of the costs associated with bankruptcy and financial distress.

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11
Q

Possible alternative strategies wrt. financial distress in comparison (8)

A
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12
Q

3 key factors influencing PV (financial distress costs)

A

Remember: VL = VU + *PV *(interest tax shield) — *PV *(financial distress costs)

  • PV *(financial distress costs) is influenced by three key factors:
    (1) probability of financial distress: increases with the amount of a firm’s liabilities relative to its assets and the volatility of its CFs and asset values.
    (2) magnitude of the costs after a firm is in distress: varying by industry
    (3) appropriate discount rate for the distress costs: lower discount rates for higher ß’s result in higher PVs
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13
Q

Summary Bankruptcy cost (3 things)

A

(1) How big are the costs of financial distress?
- direct/indirect costs
- 10-25% of pre-distress equity

(2) Should you liquidate or reorganize a firm in financial distress?
- depends on the bankruptcy code: Firm Value = Max (Merged value, going concern value, liquidation value)

(3) How does financial distress affect capital structure choices?
VL = VU + *PV *(interest tax shield) — *PV *(financial distress costs)

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