Chapter 16

Financial Distress,
Managerial Incentives,
and Information
Chapter Outline
16.1 Default and Bankruptcy in a Perfect Market
16.2 The Costs of Bankruptcy and Financial Distress
16.3 Financial Distress Costs and Firm Value
16.4 Optimal Capital Structure: The Tradeoff Theory
16.5 Exploiting Debt Holders: The Agency Costs of Leverage
16.6 Motivating Managers: The Agency Benefits of Leverage
16.7 Agency Costs and the Tradeoff Theory

16.8 Asymmetric Information and Capital Structure

16.9 Capital Structure: The Bottom Line
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Default and Bankruptcy in a Perfect Market
• Financial Distress
• When a firm has difficulty meeting its debt obligations
• Default
• When a firm fails to make the required interest or principal payments on its
debt, or violates a debt covenant
• If firm defaults, debt holders are given certain rights to the assets of the firm
and may even take legal ownership of the firm’s assets through bankruptcy.
• Bankruptcy
• An important consequence of leverage is the risk of bankruptcy.
• Equity financing does not produce this risk. Dividends are no legal obligation.
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Armin Industries: Leverage and Risk of Default
• Armin is considering a new project.
• While the new product represents a significant advance over Armin’s
competitors’ products, the products success is uncertain.
• If it is a hit, revenues and profits will grow, and Armin will be worth $150 million at the
end of the year.
• If it fails, Armin will be worth only $80 million.

• Armin may employ one of two alternative capital structures.

• It can use all-equity financing.
• It can use debt that matures at the end of the year with a total of $100 million
due.

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Scenario 1: New Product Succeeds
• If the new product is successful, Armin is worth $150 million.
• Without leverage, equity holders own the full amount.
• With leverage, Armin must make the $100 million debt payment, and Armin’s equity holders will
own the remaining $50 million.
• Even if Armin does not have $100 million in cash available at the end of the year, it will not be forced to default
on its debt.
• With perfect capital markets, as long as the value of the firm’s assets exceeds its
liabilities, Armin will be able to repay the loan.
• If it does not have the cash immediately available, it can raise the cash by obtaining a new loan or
by issuing new shares.
• If a firm has access to capital markets and can issue new securities at a fair price, then it
need not default as long as the market value of its assets exceeds its liabilities.
• Many firms experience years of negative cash flows yet remain solvent.

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Scenario 2: New Product Fails
• If the new product fails, Armin is worth only $80 million.
• Without leverage, equity holders will be unhappy, but there are no legal
consequences for the firm.
• With leverage, Armin will experience financial distress and the firm will
default, as it will be unable to repay the $100 million debt.
• In bankruptcy, debt holders will receive legal ownership of the firm’s assets, leaving
Armin’s shareholders with nothing.
• Because the assets the debt holders receive have a value of $80 million, they will suffer a
loss of $20 million.

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• Both debt and equity holders are worse off if product fails
• Without leverage: equity holders lose $70M (= $150M − $80M)
Comparing two • With leverage, equity holders lose $50M, and debt holders lose
$20M, but the total loss is the same, $70M.
Scenarios • Note: the decline in value is not caused by bankruptcy. The decline is
the same whether or not the firm has leverage.
• If the new product fails, Armin will experience economic distress,
which is a significant decline in the value of a firm’s assets, whether or
not it experiences financial distress due to leverage.
Bankruptcy and Capital Structure
In perfect capital markets, Modigliani-Miller Proposition I applies:
• The total value to all investors does not depend on the firm’s capital
structure.
• There is no disadvantage to debt financing, and a firm will have the
same total value and will be able to raise the same amount initially
from investors with either choice of capital structure.

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Textbook Example 16.1

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Bankruptcy Costs and Financial Distress
• With perfect capital markets, the risk of bankruptcy is not a
disadvantage of debt, rather bankruptcy shifts the ownership of the
firm from equity holders to debt holders without changing the total
value available to all investors.
• In reality, bankruptcy is rarely simple and straightforward. It is often a
long and complicated process that imposes both direct and indirect
costs on the firm and its investors.

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The Bankruptcy Code
• Bankruptcy codes were created so that creditors are treated fairly and
the value of the assets is not needlessly destroyed.
• U.S. firms can file for two forms of bankruptcy protection: Chapter 7
or Chapter 11 of the U.S. bankruptcy code.
• Liquidation (Chapter 7 ): A trustee is appointed to oversee the liquidation of
the firm’s assets through an auction. The proceeds from the liquidation are
used to pay the firm’s creditors, and the firm ceases to exist.
• Reorganization (Chapter 11): the more common form of bankruptcy for large
corporations.

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Reorganization (Chapter 11)
• With Chapter 11, all pending collection attempts are automatically suspended,
and the firm’s existing management is given the opportunity to propose a
reorganization plan.
• While developing the plan, management continues to operate the business.
• The reorganization plan specifies the treatment of each creditor of the firm.
• Creditors may receive cash payments and/or new debt or equity securities of the
firm.
• The value of the cash and securities is typically less than the amount each creditor is owed,
but more than the creditors would receive if the firm were shut down immediately and
liquidated.
• The creditors must vote to accept the plan, and it must be approved by the
bankruptcy court.
• If an acceptable plan is not put forth, the court may ultimately force a Chapter 7
liquidation.
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Direct Costs of Bankruptcy
• The bankruptcy process is complex, time-consuming, and costly.
• Costly outside experts are often hired by the firm to assist with the bankruptcy process.
• Creditors also incur costs during the bankruptcy process.
• They may wait several years to receive payment.
• They may hire their own experts for legal and professional advice.

• The direct costs of bankruptcy reduce the value of the assets that the firm’s
investors will ultimately receive.
• Average direct costs: 3% to 4% of market value of assets.
• Given the direct costs of bankruptcy, firms may avoid filing for bankruptcy:
• by negotiating directly with creditors an out of court reorganization
• or by negotiating a pre-packaged bankruptcy: developing a reorganization plan with the
agreement of the main creditors and then filing Chapter 11 to implement the plan. With a
prepackaged bankruptcy, the firm emerges from bankruptcy quickly and with minimal direct costs.
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Indirect Costs of Financial Distress
• While the indirect costs are difficult to measure accurately, they are often much
larger than the direct costs of bankruptcy.
• Loss of Customers
• Loss of Suppliers
• Loss of Employees
• Loss of Receivables
• Fire Sale of Assets
• Delayed Liquidation
• Costs to Creditors

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Overall Impact of Indirect Costs
• The indirect costs of financial distress may
be substantial.
• It is estimated that the potential loss due to financial distress is 10% to 20% of
firm value
• When estimating indirect costs, two important points must be
considered.
• Losses to total firm value (and not solely losses to equity holders or debt
holders, or transfers between them) must be identified.
• The incremental losses that are associated with financial distress, above and
beyond any losses that would occur due to the firm’s economic distress, must
be identified.
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Financial Distress Costs and Firm Value
• Example: Armin Industries - The Impact of Financial Distress Costs
• With all-equity financing, Armin’s assets will be worth $150 million if its new
product succeeds and $80 million if the new product fails.
• With debt of $100 million, Armin will be in bankruptcy if the product fails:
• In this case, some Armin’s assets will be lost to bankruptcy and financial distress costs.
• As a result, debt holders will receive less than $80 million.
• Assume debt holders receive $60 million after accounting for costs of financial distress.

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Textbook Example 16.2

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Who Pays for Financial Distress Costs?
• For Armin, if the new product fails, equity holders lose their investment in the
firm and will not care about bankruptcy costs.
• However, debt holders recognize that if the new product fails and the firm
defaults, they will not be able to get the full value of the assets.
• As a result, they will pay less for the debt initially (the difference being the present value of
the bankruptcy costs).
• If the debt holders initially pay less for the debt, there is less money available for
the firm to pay dividends, repurchase shares, and make investments.
• This difference actually comes out of the equity holders’ pockets.

• When securities are fairly priced, the original shareholders of a firm pay the
present value of the costs associated with bankruptcy and financial distress.

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Optimal Capital Structure: The Tradeoff Theory
• Tradeoff Theory: The firm picks its capital structure by trading off the benefits of the tax
shield from debt against the costs of financial distress.

• The total value of a levered firm equals the value of the firm without
leverage plus the present value of the tax savings from debt, less the
present value of financial distress costs.

VL = VU + PV(Interest tax shield) – PV(Financial Distress Costs)

• Why firms choose debt levels that are too low to fully exploit the interest tax
shield (due to the presence of financial distress costs)
• Differences in the use of leverage across industries (due to differences in the
magnitude of financial distress costs and the volatility of cash flows)
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Present Value of Financial Distress Costs
1. The probability of financial distress.
• increases with the amount of a firm’s liabilities (relative to its assets).
• increases with the volatility of cash flows and asset values.
2. The magnitude of the costs after a firm is in distress.
• Financial distress costs will vary by industry.
• Technology firms will likely incur high costs due to the potential for loss of customers and key
personnel, as well as a lack of tangible assets that can be easily liquidated.
• Real estate firms are likely to have low costs since their assets can be sold relatively easily
3. The appropriate discount rate for the distress costs.
• Depends on firm’s market risk
• Note that because distress costs are high when the firm does poorly, the beta of distress costs has
the opposite sign to that of the firm.
• The higher the firm’s beta, the more negative the beta of its distress costs will be
• The present value of distress costs will be higher for high beta firms.

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Optimal Leverage with Taxes and Financial Distress Costs

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Optimal Leverage
• For low levels of debt, the risk of default remains low and the main effect
of an increase in leverage is an increase in the interest tax shield.
• As the level of debt increases, the probability of default increases.
• As the level of debt increases, the costs of financial distress increase,
reducing the value of the levered firm.
• The tradeoff theory states that firms should increase their leverage until it
reaches the level for which the firm value is maximized.
• At this point, the tax savings that result from increasing leverage are
perfectly offset by the increased probability of incurring the costs of
financial distress.

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Textbook Example 16.4

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Debt Levels in Practice
• Although the tradeoff theory explains how firms should choose their
capital structures to maximize value to current shareholders, it may
not coincide with what firms actually do in practice.

• Management Entrenchment Theory (Agency Conflicts)

• A theory that suggests managers choose a capital structure to avoid the
discipline of debt and maintain their own job security
• Managers seek to minimize leverage to prevent the job loss that would
accompany financial distress, but are constrained to use some debt (to keep
shareholders happy).

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Asymmetric Information and Capital Structure
• Asymmetric Information
• A situation in which parties have different information
• For example, when managers have superior information to investors
regarding the firm’s future cash flows
• Adverse Selection
• The idea that when the buyers and sellers have different information, the
average quality of assets in the market will differ from the average quality
overall
• Lemons Principle
• When a seller has private information about the value of a good, buyers will
discount the price they are willing to pay due to adverse selection.
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Leverage as a Credible Signal
• Credibility Principle: claims in one’s self-interest are credible only if they are
backed by actions that have costs if the claims were untrue.
“Actions speak louder than words.”
• Signaling Theory of Debt
• The use of leverage as a way to signal information to investors
• use leverage as a way to convince investors that it does have information that the firm will
grow, even if it cannot provide verifiable details about the sources of growth.
• Example: a firm with profitable project, but cannot discuss the project due to
competitive reasons.
• Credibly communicate positive information by committing to large future debt payments.
• If true, the firm will have no trouble making the debt payments.
• If false, the firm will experience financial distress. This distress will be costly for the firm.

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Textbook Example 16.8

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Adverse Selection
The classic example of adverse selection and the lemons principle is the
used car market.
• If the seller has private information about the quality of the car, then his
desire to sell reveals the car is probably of low quality.
• Buyers are therefore reluctant to buy except at heavily discounted prices.
• Owners of high-quality cars are reluctant to sell because they know buyers
will think they are selling a lemon and offer only a low price.
• Consequently, the quality and prices of cars sold in the used-car market are
both low.

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Issuing Equity and Adverse Selection
• This same principle can be applied to the market for equity:
• Suppose the owner of a start-up company offers to sell you 70% of his stake in
the firm.
• He states that he is selling only because he wants to diversify.
• You suspect the owner may be eager to sell such a large stake because he may be trying
to cash out before negative information about the firm becomes public.
• Firms selling equity have private information about the quality of projects.
• Due to the lemon principle, buyers are reluctant to believe management’s assessment of
the new projects and are only willing to buy the new equity at heavily discounted prices.

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Issuing Equity and Adverse Selection
• Therefore, managers who know their prospects are good (and whose
securities will have a high value) will not sell new equity.
• Only those managers who know their firms have poor prospects (and
whose securities will have low value) are willing to sell new equity.
• The lemons problem creates a cost for firms that need to raise capital
from investors to fund new investments.
• If they try to issue equity, investors will discount the price they are
willing to pay to reflect the possibility that managers have bad news.

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Pecking Order Hypothesis
• Managers who perceive the firm’s equity is underpriced will have a preference to
fund investment using retained earnings, or debt, rather than equity.
• Managers who perceive the firm’s equity to be overpriced will prefer to issue
equity, as opposed to issuing debt or using retained earnings, to fund investment.
Pecking Order: The idea that managers will prefer to fund investments by first using
retained earnings, then debt and equity only as a last resort
• This hypothesis does not provide a clear prediction regarding capital structure. While firms
should prefer to use retained earnings, then debt, and then equity as funding sources,
retained earnings are merely another form of equity financing.
• Firms might have low leverage either because they are unable to issue additional debt or
because they are sufficiently profitable to finance all investment using retained earnings.

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 Figure 16.4 Aggregate Sources of Funding for Capital
Expenditures, U.S. Corporations

Source: Federal Reserve Flow of Funds.

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Textbook Example 16.10

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Capital Structure: The Bottom Line
• Market Timing View of Capital Structure
• The firm’s overall capital structure depends in part on the market conditions
that existed when it sought funding in the past.

• The optimal capital structure depends on market imperfections, such

as taxes, financial distress costs, agency costs, and asymmetric
information.

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Chapter Quiz
1. Does the risk of default reduce the value of the firm?
2. If a firm files for bankruptcy under Chapter 11 of the bankruptcy
code, which party gets the first opportunity to propose a plan for
the firm’s reorganization?
3. True or False: If bankruptcy costs are only incurred once the firm is
in bankruptcy and its equity is worthless, then these costs will not
affect the initial value of the firm.
4. What is the “trade-off” in the trade-off theory?
5. Describe how the management entrenchment can affect the value
of the firm.

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Chapter Quiz
6. Coca-Cola Enterprises is almost 50% debt financed, while Intel, a
technology firm, has no net debt. Why might these firms choose
such different capital structures?
7. Why might firms prefer to fund investments using retained earnings
or debt rather than issuing equity?

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