FIN 475 Lecture Notes - Lecture 8: Bankruptcy In The United States, Capital Structure, Pre-Packaged Insolvency

116 views3 pages

amethystbear668

19 Jun 2019

School

Department

Course

Professor

For unlimited access to Class Notes, a Class+ subscription is required.

Document Summary

16. 1: default and bankruptcy in a perfect market. A firm that fails to make the required interest or principal payments on the debt is in default. After the firm defaults, debt holders are given certain rights to the assets of the firm. In the extreme case, the debt holders take legal ownership of the firm"s assets through a process called bankruptcy. If a firm has access to capital markets and can issue new securities at a fair price, then it need not default as long as the market value of its assets exceeds its liabilities. If a company fails, its investors are equally unhappy whether the firm is levered and declares bankruptcy or whether it is unlevered and the share price declines. When a firm declares bankruptcy, the news often makes headlines. Much attention is paid to the firm"s poor results and the loss to investors.

Related Questions

Which of the following statements is FALSE?

Debt holders are not foolishâthey recognize that when the firm defaults, they will not be able to get the full value of the assets. As a result, they will pay less for the debt initially.

The costs of financial distress represent an important departure from Modigliani and Miller's assumption of perfect capital markets.

Levered firms risk incurring financial distress costs that reduce the cash flows available to investors.

When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

Q)Suppose the Alpha Manufacturing Corporation is experiencing extreme financial difficulties and is considering bankruptcy. Its shareholders are currently almost equally divided about whether or not the company should go bankrupt, with one outspoken faction pushing for bankruptcy and the other strongly opposing it. They have $50 million in debt all in the form of bonds, and bondholders are pretty well united in that they want the firm to declare bankruptcy.

A)The CEO announces that he is leaning against bankruptcy. This means one faction of shareholders is happy, but another faction of shareholders is very upset and the bondholders are also unhappy. Can the unhappy faction of shareholders team up with the bondholders to vote out the CEO? Explain your reasoning using references from the background readings.

B) Suppose Alpha ends up declaring bankruptcy. They do not have any cash in the bank but they own $60 million worth of real estate. They only have one type of shareholderâcommon shareholders. If they sell the real estate, how much of this will bondholders get and how much with shareholders get?

C)Now suppose that Alpha has two classes of shareholdersâcommon shareholders and preferred shareholders. Preferred shareholders are owed $20 million in dividends that have been unpaid in the last two years. If Alpha goes bankrupt and sells its $60 million worth of real estate, how much will bondholders get, how much will common shareholders get, and how much will preferred shareholders get?

V2 F1 Q1-5

Please give explanations

1) The return on assets of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm with reasonable amounts of debt.

a) True

b) False

2) Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on equity to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a) False

b) Partly true, partly false

c) True

Q3) In a world with no frictions â that is, taxes, costs of bankruptcy, asymmetric information - there is no optimal capital structure (that, is no optimal mix of debt and equity).

a) True

b) False

Q4) In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a) The relationship between return on assets and the WACC is indeterminate and depends on several factors.

b) Its return on assets is always greater than the weighted average cost of capital (WACC).

c) Its return on assets is always is equal to the weighted average cost of capital (WACC).

d) Its return on assets is always less than the weighted average cost of capital (WACC).

Q5) In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, their valuation at any point will:

a) Will depend on the capital structures adopted by the firms.

b) Will depend on the method of valuation used.

c) Will depend on the capital structures adopted by the firms and the valuation method used

d) Will be the same as each other regardless of the method of valuation.

FIN 475 Lecture Notes - Lecture 8: Bankruptcy In The United States, Capital Structure, Pre-Packaged Insolvency

Document Summary

Get access

Related Documents

FIN 475 Lecture Notes - Lecture 6: Agency Cost, Net Present Value, Capital Structure

FIN 475 Lecture Notes - Lecture 5: Tax Shield, Capital Structure

FIN 475 Lecture Notes - Lecture 4: George Akerlof, Capital Structure, Adverse Selection

Related Questions