Wednesday, April 18, 2012

Costs of Financial Distress and Financial Strategy

Continuing on in our series about perfect capital market assumptions and what occurs when we confront reality, with this post we turn towards the concept of “Financial Distress”, #3 on our list.
The previous topics we have looked at – Perfect Information and Taxes – have had relatively straightforward implications when we have examined reality’s divergence from the perfect capital market assumptions. This is not the case when it comes to Financial Distress.

What is “Financial Distress”?
Financial Distress is not very easily defined - ask five people what it means and you will likely get five different answers. We can take a point of view that varies along a wide continuum, from limited scope to broad.
At one end (the “strict view”), it is the costs of going into bankruptcy – legal fees, court fees, etc. It is not the loss of stock value, etc., but literally just the cost associated with the event. At the other (the “expanded view”), if one can only afford a Fiat rather than a Ferrari this can be construed as “distress” by some.
Fundamentally, what these extremes have in common is the fact that there are not sufficient funds available to make necessary expenditures (the key word being “necessary”, and this is subjectively defined).

Bankruptcy events are the most obvious financial distress situations. In some cases bankruptcy results the reorganization of the firm, after which time it “emerges” in a transformed state. Often this occurs with losses to former debt and equity holders. In other situations bankruptcy results the cessation of the entity as a going concern and ultimately results in that entity’s liquidation.
Figure A
Theoretically, the cost of financial distress in the bankruptcy situation can be calculated. Simply add up the additional costs of filing for bankruptcy (legal fees, court fees, etc.), along with the losses to debt and equity holders, and multiply this times the probability of the firm going bankrupt (Figure A).

While Great in Theory…
Practically speaking, this is not so simple. How does one determine the probability of bankruptcy?
The major ratings agencies, Moodys and Standard and Poor’s, have a wealth of historical data on default frequency and losses given default for securities that they provide ratings for (I have not linked this as they require a subscription). This data can be useful for some purposes, such as pricing rated debt.
However, this is not the full universe of companies. The local corner coffee shop or your Uncle John’s farm are probably not rated by either ratings agency. In statistical speak, the ratings agency data are not a representative sample, and therefore we cannot confidently draw conclusions from this data for every type of firm.

Financial Distress Can Be So Much More
Even if we had representative data, using an “expanded view” of financial distress leads us to other costs that are not captured in that calculation.
Let us say that we are shareholders in Farmco. Last year, Farmco generated ²10 in cash (the symbol ² representing Treasury Café Monetary Units, or TCMU’s). Let’s further say that Farmco has a dividend of ²8 per year. This indicates that Farmco retains ²2 per year. As discussed in our initial Financial Strategy post, we expect that Farmco invests these funds at our cost of capital, which for the sake of this example we say is 10%.
In the farming business, one can increase crop yields by installing drainage tile in areas that have higher than normal wetness. This wetness may come about due to the slope of the field, the elevation of the field relative to its neighbors, waterways, etc.
If we could install drainage tile on Farmco’s eligible sites, we could generate an additional ²1 per year due to the incrementally higher yield. If we have a 10% cost of capital, we would be willing to make this investment so long as it did not require more than ²10 (using the Dividend Discount Model and assuming the investment lasts forever).

Figure B
However, due to the fact that Perfect Capital Market Assumption #1 (perfect information by all participants) does not hold, we are able to make this investment for ²5 instead, which means this investment will yield 20%, a significant premium to our 10% requirement.
Figure B shows the result of this on the value of Farmco (an increase of slightly more than ²3 from the base value calculated in our last post) under the fully retained cash condition.  
However, due to Farmco’s dividend policy, it only has ²2 available to make this investment. If it chooses to cut its dividend, as we discussed in Apple’s Dividend – A Good Financial Strategy?, this will provide a negative signal to the market, offsetting part or all of the additional return this investment opportunity presents.
Figure C
By funding internally but delaying part of the investment until year 1 and year 2 when it has the funds, Farmco executes the investment opportunity and realizes the value, but on a delayed basis. This impacts its ultimate return, due to the time value of money, by about ²0.35. The delay in activity and subsequent valuation are shown in Figure C.
Income and investment opportunities that are delayed or forgone are also, in the broad view, costs of financial distress.

Yet the Costs of Financial Distress Remain a Mystery
The big problem, however, is that fact that these factors are never objectively known or able to be quantified precisely ahead of time. In fact, shareholder’s likely will never know. After year 1 Farmco will probably not say “we had ²5 in investment opportunity at 20% and only did ²2”, rather it will state “we made great investments this year, and remain expectant that, through our business development efforts, we are confident that other similar opportunities may present themselves in the future”. This is a very difficult statement to infer costs of financial distress from.
The fact that the true costs of financial distress cannot be measured, let alone determined, makes this cost a very “theoretical” exercise, which does not lend itself well to organizational decision-making processes. These are usually attuned to “hard” numbers rather than theoretical ones, yet the fact remains that opportunities were not taken and shareholder value suffered as a result.

Key Takeaways
Costs of Financial Distress are great in theory, and can be used to explain events that occur in financial management of organizations and in the markets. Costs of Financial Distress are real, even if they cannot be measured. Because of this, they may not always be taken sufficiently into account.
·         What examples do you have of the Costs of Financial Distress?

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