Introductory Corporate Finance: Leverage - Financial Distress and Bankruptcy, Costs Direct vs. Indirect Costs Tradeoff Theory

What This Is

Financial distress and bankruptcy costs refer to the direct and indirect costs associated with a company's potential or actual bankruptcy. These costs can significantly impact a firm's value and decision-making. For instance, consider a company like General Electric (GE), which has faced financial distress in the past. In 2008, GE's market value plummeted to $70 billion, down from $400 billion in 2007. The direct costs of bankruptcy, such as legal fees and restructuring expenses, were estimated to be around $1 billion. However, the indirect costs, including the loss of customer trust and the impact on the company's reputation, were likely much higher.

Key Formulas & Models

• Direct Bankruptcy Costs (DBC) = Legal fees + Restructuring expenses + Other costs: Direct costs associated with bankruptcy, such as legal fees, restructuring expenses, and other costs.
• Indirect Bankruptcy Costs (IBC) = Loss of customer trust + Reputation damage + Opportunity costs: Indirect costs associated with bankruptcy, such as the loss of customer trust, reputation damage, and opportunity costs.
• Trade-off Theory: DBC + IBC = (WACC - g) / (1 - g): The trade-off theory suggests that the costs of financial distress are equal to the present value of the expected cash flows that the firm would have generated if it had not gone bankrupt.
• Z-score = (Current assets - Current liabilities) / Total assets + (Retained earnings / Total assets) + (Earnings before interest and taxes / Total assets): A measure of a company's financial health, with higher values indicating lower bankruptcy risk.
• Altman Z-score = 1.2X + 1.4Y + 3.3Z + 0.6W + 0.99J: A more complex version of the Z-score, with different weights assigned to each variable.
• Expected bankruptcy cost (EBC) = (1 - P) * DBC + P * IBC: The expected bankruptcy cost is the product of the probability of bankruptcy and the expected costs of bankruptcy.
• Probability of bankruptcy (P) = 1 / (1 + e^(-Z)): The probability of bankruptcy is a function of the Z-score, with higher values indicating lower bankruptcy risk.
• Expected cash flow (ECF) = (1 - P) * EBIT + P * IBC: The expected cash flow is the product of the probability of bankruptcy and the expected cash flows that the firm would have generated if it had not gone bankrupt.

Step-by-Step Calculation

1. Calculate the direct bankruptcy costs (DBC) by adding up the legal fees, restructuring expenses, and other costs.
2. Calculate the indirect bankruptcy costs (IBC) by estimating the loss of customer trust, reputation damage, and opportunity costs.
3. Calculate the trade-off theory by using the formula: DBC + IBC = (WACC - g) / (1 - g).
4. Calculate the Z-score by using the formula: Z-score = (Current assets - Current liabilities) / Total assets + (Retained earnings / Total assets) + (Earnings before interest and taxes / Total assets).
5. Calculate the Altman Z-score by using the formula: Altman Z-score = 1.2X + 1.4Y + 3.3Z + 0.6W + 0.99J.
6. Calculate the expected bankruptcy cost (EBC) by using the formula: EBC = (1 - P) * DBC + P * IBC.

Common Mistakes

• Mistake: Using the wrong formula for the Z-score or Altman Z-score.
• Correction: Make sure to use the correct formula and weights for each variable.
• Mistake: Ignoring the indirect bankruptcy costs (IBC).
• Correction: Include IBC in the calculation of the expected bankruptcy cost (EBC).
• Mistake: Using the wrong probability of bankruptcy (P).
• Correction: Use the correct formula for P, which is a function of the Z-score.

Exam / CFA Tips

• Tip: Be careful when using the trade-off theory, as it assumes that the costs of financial distress are equal to the present value of the expected cash flows that the firm would have generated if it had not gone bankrupt.
• Tip: Make sure to distinguish between the direct and indirect bankruptcy costs (DBC and IBC).
• Tip: Be aware of the different formulas for the Z-score and Altman Z-score.

Quick Practice Problem

A company has EBIT of $10M, interest of $2M, and tax of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT + Interest) / EBIT = ($10M + $2M) / $10M = 2.

Explanation: The degree of financial leverage (DFL) is a measure of the sensitivity of a company's earnings to changes in its capital structure.

Last-Minute Cram Sheet

• Direct Bankruptcy Costs (DBC): Legal fees, restructuring expenses, and other costs associated with bankruptcy.
• Indirect Bankruptcy Costs (IBC): Loss of customer trust, reputation damage, and opportunity costs associated with bankruptcy.
• Trade-off Theory: The costs of financial distress are equal to the present value of the expected cash flows that the firm would have generated if it had not gone bankrupt.
• Z-score: A measure of a company's financial health, with higher values indicating lower bankruptcy risk.
• Altman Z-score: A more complex version of the Z-score, with different weights assigned to each variable.
• Expected Bankruptcy Cost (EBC): The product of the probability of bankruptcy and the expected costs of bankruptcy.
• Probability of Bankruptcy (P): A function of the Z-score, with higher values indicating lower bankruptcy risk.
• Expected Cash Flow (ECF): The product of the probability of bankruptcy and the expected cash flows that the firm would have generated if it had not gone bankrupt.
• Degree of Financial Leverage (DFL): A measure of the sensitivity of a company's earnings to changes in its capital structure.
• In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.