Lecture 3- Gearing (part 2)

Financial distress- When firm experiences [blank_start]significant problem[blank_end] in meeting its [blank_start]debt obligations[blank_end]

Bankruptcy- Economically a firm goes [blank_start]bankrupt[blank_end] when [blank_start]value[blank_end] of its [blank_start]assets[blank_end] [blank_start]equal[blank_end] to its [blank_start]debt[blank_end] therefore, [blank_start]equity[blank_end] has no value

Direct bankruptcy costs- [blank_start]Costs[blank_end] that are [blank_start]directly associated[blank_end] with [blank_start]bankruptcy[blank_end], such as [blank_start]legal[blank_end] and [blank_start]administrative[blank_end] expenses

Indirect bankruptcy costs- [blank_start]Costs[blank_end] of avoiding [blank_start]bankruptcy filing[blank_end] incurred by [blank_start]financially distressed[blank_end] firm

Financial distress costs- [blank_start]Direct[blank_end] & [blank_start]indirect[blank_end] costs associated with going [blank_start]bankrupt[blank_end] or experiencing [blank_start]financial distress[blank_end]

One type of indirect cost of financial distress is [blank_start]impaired ability[blank_end] to [blank_start]conduct business[blank_end]. Business not able to [blank_start]continue[blank_end] their [blank_start]operations[blank_end] with [blank_start]same[blank_end] condition as before. Suppliers & customers [blank_start]reluctant[blank_end] to do business

Another type of indirect cost of financial distress is [blank_start]agency cost[blank_end] ([blank_start]conflict[blank_end] of [blank_start]interest[blank_end] between [blank_start]bondholders[blank_end] & [blank_start]shareholders[blank_end])

One type of agency cost is [blank_start]incentive[blank_end] to [blank_start]underinvestment[blank_end]. Company [blank_start]under invests[blank_end] on [blank_start]positive NPV projects[blank_end] when experiencing financial distress & when [blank_start]shareholders[blank_end] perceive these [blank_start]projects[blank_end] to benefit [blank_start]bondholders[blank_end] rather than them

Another type of agency cost is [blank_start]incentive[blank_end] to take [blank_start]large risks[blank_end]

Third type of agency cost is [blank_start]milking[blank_end] the [blank_start]property[blank_end]. Managers & shareholders decide to [blank_start]pay extra dividends[blank_end] or other distributions in times of [blank_start]financial distress[blank_end], leaving [blank_start]less[blank_end] in firm for [blank_start]bondholders[blank_end]

Covenant- [blank_start]Legal agreement[blank_end] between [blank_start]lender[blank_end] & [blank_start]borrower[blank_end] to protect [blank_start]borrower[blank_end]

Static theory of capital structure- Firm [blank_start]borrows[blank_end] up to point where [blank_start]tax benefit[blank_end] from an extra pound or euro in [blank_start]debt[blank_end] is [blank_start]exactly equal[blank_end] to [blank_start]cost[blank_end] that comes from [blank_start]increased probability[blank_end] of financial distress

Pecking order theory- Firm must first use [blank_start]internal financing[blank_end] to [blank_start]fund[blank_end] an [blank_start]investment[blank_end]. If this [blank_start]internal financing[blank_end] isn't enough they should [blank_start]issue debt[blank_end] because it's cheaper form of [blank_start]funding[blank_end] & creates [blank_start]tax shield[blank_end]. Finally, [blank_start]issue equity[blank_end] as last resort

In market timing theory managers [blank_start]issue equity[blank_end] when its [blank_start]market value[blank_end] is high relative to [blank_start]book values[blank_end] & [blank_start]issue debt[blank_end] when [blank_start]market value[blank_end] of equity is low relative to its [blank_start]book values[blank_end]

Liquidation- [blank_start]Termination[blank_end] of firm as a [blank_start]going concern[blank_end]

Reorganisation- [blank_start]Financial restructuring[blank_end] of [blank_start]failing[blank_end] firm to attempt to [blank_start]continue operations[blank_end] as a [blank_start]going concern[blank_end]