If it cannot be diversified away investing in this

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Unformatted text preview: f the two companies for the particular state. Possible states Rain-Rain Rain-Warm Rain-Hot Warm-Warm Warm-Hot Hot-Hot $200,000 + 200,000 = $200,000 + 350,000 = $200,000 + 800,000 = $350,000 + 350,000 = $350,000 + 800,000 = $800,000 + 800,000 = Joint value $400,000 550,000 1,000,000 700,000 1,150,000 1,600,000 552 b. Recall that if a firm cannot service its debt, the bondholders receive the value of the assets. Thus, the value of the debt is reduced to the value of the company if the face value of the debt is greater than the value of the company. If the value of the company is greater than the value of the debt, the value of the debt is its face value. Here, the value of the common stock is always the residual value of the firm over the value of the debt. So, the value of the debt and the value of the stock in each state is: Possible states Rain-Rain Rain-Warm Rain-Hot Warm-Warm Warm-Hot Hot-Hot Joint Prob. .01 .08 .10 .16 .40 .25 Joint Value $400,000 550,000 1,000,000 700,000 1,150,000 1,600,000 Debt Value $400,000 550,000 700,000 700,000 700,000 700,000 Stock Value $0 0 300,000 0 450,000 900,000 c. The bondholders are better off if the value of the debt after the merger is greater than the value of the debt before the merger. The value of the debt is the smaller of the debt value or the company value. So, the value of the debt of each individual company before the merger in each state is: Possible states Rain Warm Hot Probability .10 .40 .50 Debt Value $200,000 350,000 350,000 Individual debt value = .1($200,000) + .4($350,000) + .5($350,000) Individual debt value = $335,000 This means the total value of the debt for both companies pre-merger must be: Total debt value pre-merger = 2($335,000) Total debt value pre-merger = $670,000 To get the expected debt value, post-merger, we can use the joint probabilities for each possible state and the debt values corresponding to each state we found in part c. Using this information to find the value of the debt in the post-merger firm, we get: Total debt value post-merger = .01($400,000) + .08($550,000) + .10($700,000) + .16($700,000) + .40($700,000) + .25($700,000) Total debt value post-merger = $685,000 The bondholders are better off by $15,000. Since we have already shown that the total value of the combined company is the same as the sum of the value of the individual companies, the implication is that the stockholders are worse off by $15,000. 553 CHAPTER 30 FINANCIAL DISTRESS Answers to Concepts Review and Critical Thinking Questions 1. Financial distress is often linked to insolvency. Stock-based insolvency occurs when a firm has a negative net worth. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations. Financial distress frequently can serve as a firm’s “early warning” sign for trouble. Thus, it can be beneficial since it may bring about new organizational forms and new operating strategies. A prepackaged bankruptcy is where the firm and most creditors agree to a private reorganization before bankruptcy takes place. After the private agreement, the firm files for formal bankruptcy. The biggest advantage is that a prepackaged bankruptcy is usually cheaper and faster than a traditional bankruptcy. Just because a firm is experiencing financial distress doesn’t necessarily imply the firm is worth more dead than alive. Liquidation occurs when the assets of a firm are sold and payments are made to creditors (usually based upon the APR). Reorganization is the restructuring of the firm's finances. The absolute priority rule is the priority rule of the distribution of the proceeds of the liquidation. It begins with the first claim to the last, in the order: administrative expenses, unsecured claims after a filing of involuntary bankruptcy petition, wages, employee benefit plans, consumer claims, taxes, secured and unsecured loans, preferred stocks and common stocks. Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt. This new debt is called DIP (debtor in possession) debt. If DIP loans were not senior to all other debt, a firm in bankruptcy would be unable to obtain financing necessary to continue operations while in bankruptcy since the lender would be unlikely to make the loan. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders’ best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable use of the process. 2. 3. 4. 5. 6. 7. 8. 9. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it. If the only way a firm can continue to operate is to reduce labor costs, it may be a benefit to everyone, inclu...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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