Indirect Costs of Financial Distress
Loss of Customers, Suppliers, Employees, Receivables
Fire Sale of Assets
Delayed Liquidation
Costs to Creditors
Direct Costs of Bankruptcy
Average costs of bankruptcy are approx. 3-4% of the pre-bankruptcy market value
Costly outside experts (RX bankers, Lawyers)
Delayed payments
Who pays for distress costs?
If securities are fairly priced, the orignal shareholders pay the PV of financial distress costs
Tradeoff Theory
The firm picks its capital structure by trading off the benefits of tax shield against the cost of financial distress and agency costs
Firms increase leverage until they maximize firm value
Management Entranchement
A situation arsing as the result of the separation of ownership and control in which managers may make decisions that benefit themselves at investors expenses
Wasteful Investment
Managers may make large unprofitable investments reffered to as empire building
Managers of large firms earn higher salaries and gain greater prestige
Thus they may expand unprofitable divisions
Free Cash Flow Hypothesis
Wasteful spending is more likely when firms have high levels of cash flow in excess of what is needed after making all positive-NPV investments and payments to debt holders
Reduction of wasteful spending
Leverage can reduce the degree of managerial entrenchement because managers are more likely to be fired if a firm faces financial distress
In addition, highly levered firms are closely monitored by creditors and have thus an addditional layer of management oversight
Name the different mechanisms for a share repurchase
Open Market Repurchase
Tender Offer
Targeted Repurchase
Do option holder prefer share repurchases or dividend?
Option holders do not receive dividends and only experience losses due to falling prices (ex-dividend) - therefore they prefer share repurchases
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