FIN 620-session 11 lecture-1

FIN 620-session 11 lecture-1 - FIN 620 Capital Markets,...

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FIN 620 Capital Markets, Institutions, and Long-Term Financial Management Session 11 1. Lecture Notes/Comments RWJ, Chapter 30 What Is Financial Distress? The text defines financial distress as: "a situation where a firm's operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action." The most important point is that the firm is forced to take actions that it would not otherwise choose. Insolvency : - Stock-based insolvency occurs when the value of assets is less than the value of promised payments to debt. - Flow-based insolvency occurs when operating cash flows are insufficient to cover contractually required payments. Flow-based insolvency typically results in more immediate actions, and often leads to bankruptcy. Stock-based insolvency is commonly regarded as a signal of financial distress. For example, during the S&L crisis many U.S. banks and S&L's were solvent in terms of cash flow but were stock based insolvent, i.e., asset values were below liability values. Current accounting and regulatory practices allow S&L's to continue operating despite stock based insolvency. Stock-based insolvent S&L's often are not reorganized by the Resolution Trust Corporation (RTC) until they face a flow based crisis. The RTC is the federal agency charged with reorganizing the assets and liabilities of insolvent financial institutions. What Happens in Financial Distress? Financial distress can serve as the firm's "early warning" signal. Ironically, firms with high financial leverage often face financial distress earlier and, therefore, have more time to reorganize. Firms with low leverage may not recognize they are in distress until too late. A firm can respond to financial distress by increasing available cash flows (asset restructuring) or by reducing liabilities (financial restructuring). Low leverage firms have very limited options in financial restructuring, and, due to delay in their response, the asset values have often deteriorated. For these reasons, firms with low financial leverage
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are more likely to liquidate than firms with high leverage. Means to overcome financial distress include: 1. Asset Restructuring Asset Restructuring by selling major assets: When Chrysler Corporation was in distress in 1980, it sold its 'Crown Jewel' – its highly profitable division that produced tanks for the U.S. military. Merging with another firm; Reducing capital spending and R&D spending. Reduced capital spending makes sense if the foregone projects have negative NPV, perhaps due to a rise in the cost of capital in the presence of bankruptcy risk. However, if reduced investment is in response to "Selfish strategy #2: Incentive to underinvest" from an earlier chapter,
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FIN 620-session 11 lecture-1 - FIN 620 Capital Markets,...

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