Financial Distress EC 1745 - iSites.pdfVIP

Financial Distress EC 1745 Borja Larrain Today: 1. Costs of financial distress. 2. Trade-offtheory of capital structure. 3. Empirical estimates of the costs of financial distress. 4. Bankruptcy. Readings: Chapter 18 Welch In this class: • What if defaulting on your debt is not costless? Is capital structure irrelevant? • How big are the costs of financial distress? • Is financial distress the same thing as economic dis- tress? • Is a liquidity problem the same thing as a solvency problem? Are these two things easy to distinguish in practice? • What does bankruptcy imply for a company? 1 Costs of Financial Distress (FD) • Financial distress means a company is in trouble with creditors (e.g., the company missed an interest pay- ment). • It does not necessarily mean the projects of the firm are worthless. It could just be a cash flow situa- tion. Remember: cash flows can vary a lot from year to year; interest or bond coupons don’t. • Probably running into a situation like this is not cost- less: a slice of the pizza is lost, i.e., it does not end up in the hands of debtholders or shareholders. • Example: A firm has cash flows tomorrow of $150 (good state) or $50 (bad state) with probability 50% each. It has debt that promises to pay $80 next year. If there is default, lawyers charge a $5 fee. The cash flows to investors are: w/o cost of FD w/ cost of FD Debt Equity Debt Equity Lawyers Good 80 70 80 70 0 Bad 50 0 45 0 5 • So far we have assumed in this class that we are in a situation without costs of financial di