Associated with financial distress is a cost that

Associated with financial distress is a cost that would not have been imposed in
the absence of debt.
Management options under financial distress:
 Restructure liabilities: negotiate and restructure debt claims, raise new
capital
 Restructure assets: asset sales, layoffs (ontslagen)
 Declare bankruptcy:
- Liquidation: court appoints trustee to liquidate assets (de rechter kiest
een curator), cash will be distributed following a strict schedule (secured
claims, wages, taxes, unsecured claims, equity).
- Reorganization: debtor, debtor-in-possession, proposes reorganization
plan in court
Example:
In a perfect capital market, there are no cost of financial distress (transfer of
ownership from equityholders to debtholders, no reduction in cash flows
generated by the firm).
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Cost of financial distress (legal expenses, court costs, advisory fees etc.):
 Interest and principal payments to debtholders are legal obligations
(wettelijke verplichtingen).
 Dividends are common but voluntary (vrijwillig)
Only failed payments to debtholders have negative legal consequences related
with costs.
Economists broadly agree that direct cost of financial distress are too small to
account for the low debt ratios we see in reality. But there are other, indirect
costs of financial distress (loss of customers, suppliers, employees, receivables,
fire sales of assets, delayed liquidation) that could potentially be much more
important.
It is very difficult to quantify indirect costs of financial distress. We need to
estimate losses to total value and we need to estimate incremental losses of
financial distress are independent of economic distress. Many indirect costs are
incurred prior and irrespective of whether actual bankruptcy occurs. Therefore,
the economic magnitude may be more important.
Hoorcollege 4 – 5 november 2014
Managers dislike leverage: larger fraction of free cash flows reserved for interest
payments and thereby not under manager’s control, managers are most likely
fired in states of financial distress.
Agency conflicts: costly disagreements among stakeholders in a firm. Conflicts
between managers, shareholders and debtholders.
1. Managers maximize shareholder value: managers and shareholder
interests are aligned, conflict between shareholder and debtholder.
2. Managers follow own objectives: conflict between manager and
shareholder, potential conflict between manager and debtholder.
Agency conflicts between managers and investors
Agency costs of debt
 Wealth Transfers: by issuing additional debt of equal seniority, a firm
makes existing debtholders’ claims more risky to the benefit of
shareholders. Debtholders, a senior claimants to a firm’s cash flows, are
worried about dilutions to their detriment (nadeel).