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Costs of Financial Distress

Costs of Financial Distress - HAAS SCHOOL OF BUSINESS...

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H AAS S CHOOL OF B USINESS U NIVERSITY OF C ALIFORNIA AT B ERKELEY UGBA 103 © A VINASH V ERMA C LAIM - HOLDER C ONFLICTS IN F INANCIAL D ISTRESS : D ISTORTION OF V ALUE M AXIMIZATION I NCENTIVES This short note discusses two broad categories of distortions in value maximization incentives that occur when a firm is in financial distress. 1. Suppose a financially distressed firm has debt of $5 million due next period . This amount includes both interest and repayment of the principal. In market value terms, the balance sheet of the firm is summarized below: A SSETS L IABILITIES C ASH $1M D EBT $3M – ε F IXED A SSETS $2M E QUITY ε T OTAL A SSETS $3M T OTAL L IABILITIES $3M Here, ε stands for a very small amount. In all likelihood, this firm will be bankrupt next period. But, to the extent that there is a small probability that the firm can recover from financial distress, the value of its equity is a small positive amount. The market value of debt is arrived at as the difference between the market value of the assets and the market value of equity. Therefore, it is almost $3 million. Now suppose the firm has to decide on a one-period project with an outlay of $1 million. We are also given that next period, the project will generate a
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