Chapter 19: Financial Distress, Agency Costs & Information

AFM 274 · The costs side of debt · pairs with the Ch. 17 (perfect markets) and Ch. 18 (taxes) sheets

The one-line story: Ch. 18 says debt adds value via the tax shield, so why not 100% debt? Because past a point debt triggers distress costs and bad shareholder behaviour; the optimum D^* balances all of it, and information problems make firms prefer internal funds → debt → equity last.

Master Formula: Full Tradeoff Theory this organizes the entire chapter

V^L = V^U + PV(ITS) − PV(distress costs) − PV(agency costs of debt) + PV(agency benefits of debt)

Ch. 17 base
business value

Ch. 18 benefit
= t_cD if permanent

bankruptcy is costly
(direct + indirect)

gambling +
under-investment

debt disciplines
managers

The distress chain: know the terms

trouble paying = financial distress→ missed payment = default→ creditors take assets = bankruptcy

Insolvency (can't repay debts), two flavours: stock-based = liabilities > assets · flow-based = cash flow can't cover payments.
Flow-based insolvency ≠ death: if asset value is high, firm may raise funds to bridge the gap.
Equity never causes bankruptcy, dividends are optional, interest is a legal obligation.

Bankruptcy in Canada: two routes

	Liquidation	Reorganization
Firm	terminated	kept alive (going concern)
How	sell assets, pay creditors by priority	issue new securities to replace old
Act	BIA, smaller firms	CCAA, larger firms

Workout = negotiate directly with creditors, skip court. Prepackaged bankruptcy = agree on plan first, then file to bind holdout creditors.

Costs of financial distress

	Direct	Indirect
What	lawyers, accountants, courts, bankers	lost customers, suppliers, employees; fire sales; distracted management
Size	≈ 3–4% of pre-bankruptcy assets	hard to measure, often much larger

Costs hit only in default states. One-period PV:

PV(distress costs) = prob(distress) × cost1 + r

Who bears them? Shareholders. Lenders foresee default risk and pay less for the debt today, the expected cost comes out of the share price at issuance, not out of debtholders later.

Worked: who bears the cost (slide numbers)

Assets in 1 yr: $250K or $180K (50/50), β=0, r_f=4%, debt face $200K, bankruptcy cost $30K.

Payoffs	Good	Bad (default)
Assets	250,000	180,000
Bankruptcy costs	0	−30,000
Debt receives	200,000	150,000
Equity receives	50,000	0

V (no costs) = 215,000/1.04 = $206,731 · V (with costs) = 200,000/1.04 = $192,308.
Value lost = $14,423 = ½(30,000)/1.04, exactly PV(bankruptcy costs). The $30K vaporizes: no investor gets it, the pie shrinks.

Optimal leverage D^*: the hump curve

Low debt: distress ≈ impossible → adding debt ≈ pure ITS gain → V^L rises.
High debt: distress probability soars → costs overwhelm ITS → V^L falls.
D^* = peak: marginal ITS benefit = marginal distress cost

Firm type	D^*	Why
Mature / stable / utility	High	steady cash flows, tangible assets, low distress costs
R&D / tech / growth	Low	volatile EBIT, intangible assets evaporate in distress, low taxable income

Agency cost 1: Asset substitution (gambling)

Setup: $10 cash, owes $50 next yr → equity worth $0 if nothing changes.

Bet: invest the $10 → 10% chance of $100, else $0, r = 50%.

NPV = 10/1.5 − 10 = −$3.33, value-destroying. But equity: $0 → 0.1(100−50)/1.5 = +$3.33; debt: $10 → $3.33 (loses $6.67).

Heads equity wins, tails debt loses, distressed shareholders take −NPV gambles funded with debtholders' money.

Agency cost 2: Debt overhang (under-investment)

Setup: $0 cash, owes $50 next yr.

Project: invest $30 → $60 for sure, r = 10%. NPV = 60/1.1 − 30 = +$24.55.

But the $60 repays debt first ($50). Equity funds $30, gets $10 → 10/1.1 − 30 = −$20.91 → refuses. Debt would gain $45.45.

+NPV project dies because debtholders capture the benefit.

Memory hook: underwater equity gambles with money it has, won't invest money it doesn't. Fixes: covenants (cost: monitoring), shorter-term debt, consolidate lenders.

Agency benefit: debt disciplines managers

With no debt + lots of cash, managers can waste: perks, empire building, pet projects (= management entrenchment, ownership separated from control, boards rarely fire).
Mandatory interest payments leave no slack for waste; leverage also lets owner-managers keep bigger equity stakes → better decisions.
Entrenchment theory: managers personally prefer low debt (job security, avoid discipline) → real-world leverage often below D^*.

Asymmetric information: managers know more

Signaling (debt = credible bragging): talk is free; debt is a commitment that crushes a weak firm. Credibility principle, a claim is believable only if faking it would be too costly. ⟹ leverage ↑ announcement = good news, stock ↑.

Adverse selection (lemons): issuing equity makes investors ask "why sell now?" → infer stock is overvalued → price falls on announcement (rises before, managers time it). Mitigate: issue just after earnings, when the info gap is smallest. Undervalued firms simply won't issue.

Pecking order hypothesis

1. Retained earnings ≻ 2. Debt ≻ 3. New equity

RE: zero adverse selection · Debt: mild (safer, less info-sensitive) · Equity: worst signal, last resort.
Contrast for exam: tradeoff theory → firm has a target D^*; pecking order → no target, just take the cheapest-signal source available.
Evidence: most firms have targets and follow pecking order somewhat; leverage ↑ tends to raise firm value (ITS? signaling?); high-growth industries carry less debt.

Active Recall: Cover the Grey Answers

1. State the full tradeoff formula. V^L = V^U + PV(ITS) − PV(distress costs) − PV(agency costs) + PV(agency benefits).

2. Direct vs. indirect distress costs? Direct = legal/admin, ≈3–4% of assets. Indirect = lost customers/suppliers/employees, bigger, harder to measure.

3. Who bears distress costs, and when? Shareholders, at issuance, lenders anticipate default and pay less for the debt up front.

4. Asset substitution in one line. Near-insolvent equity takes −NPV gambles: keeps the upside, debtholders eat the downside.

5. Debt overhang in one line. Equity rejects +NPV safe projects because the payoff mostly repays debt, under-investment.

6. Why can too little debt be bad? Lost tax shield + entrenchment waste (perks, empire building), debt's discipline is forgone.

7. Stock reaction: leverage ↑ vs. equity issue? Leverage ↑ = good signal, price ↑. Equity issue = overvaluation signal, price ↓ post-announcement.

8. BIA vs. CCAA? BIA = smaller firms (often liquidation); CCAA = larger firms (reorganization, going concern).

9. Pecking order? Retained earnings → debt → new equity (last resort); implies no target debt ratio.

10. Which firms lever up; which don't? Stable/tangible (utilities) → high D^*; growth/R&D/intangible → low D^*.

AFM 274 Ch. 19 quick sheet · conceptual chapter, marks come from definitions, the two agency examples, and the tradeoff logic · all numbers from lecture slides, internally verified.