Tutorial 2:What is the role of debt enforcement or bankruptcy codes in each country in predicting financial distress costs in firms? Flashcards
How does debt enforcement affect shareholder wealth & investment strategies?
Bankruptcy codes that favor debt enforcement DECREASE SHAREHOLDER WEALTH –> debtholders have higher claim on firm’s assets in default situations whereas shareholders lower in hierarchy of claims may receive reduced or no payments after debtholders are compensated –> INCREASED INVESTMENT DISTORTIONS as shareholders may face pressure to avoid risky investments w higher probability of default however they may be less profitable in long-term, decreasing firms’ innovation/R&D.
How does debt enforcement differ between countries?
1) LESS INVESTMENT IN COUNTRIES W STRICTER DEBT ENFORCEMENT –> strict enforcement of debt contracts in default scenarios may disincentivise distressed firms to undertake new investments or projects as they prioritize debt repayment to avoid default consequences –> distressed firms to adopt a more conservative investment approach –> lower levels of investment.
2) LOWER ASSET GROWTH RATES IN COUNTRIES W STRICTER DEBT ENFORCEMENT –> distressed firms may experience reduced investment levels in focusing on maintaining liquidity to meet debt obligations rather than investing in growth initiatives within business.
3) RISKIER IN TERMS OF EQUITY VOLATILITY IN COUNTRIES W STRICTER DEBT ENFORCEMENT –> heightened enforcement of debt contracts can increase financial risk & uncertainty faced by distressed firms due to emphasis on debt repayment & decreased investment.
What is the effect of imperfect debt enforcement during distressed times?
When enforcement of debt contracts in default not fully efficient/stringent so limited in ability of creditors to recover debts from defaulting debtors –> REDUCES DEBTHOLDER-SHAREHOLDER CONFLICTS OF INTEREST:
1) REDUCES ASSET RISK –> firms can focus on maintaining operational continuity by preserving key assets w/out being forced into distress sales/liquidation due to stringent debt enforcement actions hence firm is more resilient to mkt volatility.
2) RAISES SHAREHOLDERS’ EXPECTED RECOVERY –> shareholders may have a better chance of recovering some value in default scenarios, as focus is not solely on satisfying debtholders’ claims at expense of shareholders –> increased shareholder protection incentivises investment in firms.
3) MITIGATES DISTORTIONS ON INVESTMENT STRATEGIES E.G. ASSET SUBSTITUTION & DEBT OVERHANG –> allows firms to make decisions based on long-term value creation rather than short-term debt obligations so firms can prioritise high-growth investments i.e. +ve NPV projects, even in challenging financial circumstances –> decreases distortions caused by agency conflicts near insolvency –> when there certainty in debt enforcement, shareholders have less incentive to engage in risky investments that could jeopardize firm’s financial stability.
