Lecture 8 - Debt and Leverage Flashcards Preview

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Flashcards in Lecture 8 - Debt and Leverage Deck (17)
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1
Q

Debt – Why Study?

A
  • Lender Influence/ Interactive corporate governance

* Effect of bankruptcy overhang on manager behavior

2
Q

Different forms of borrowing:

A

o Bank loans

o Bonds

3
Q

Bank Loans - lender influence

A
• Information
• Incentives
• Expertise
• Enforcement
“Lenders commonly influence— sometimes even dictate—critical corporate policy choices, especially as to financial and investment policy and management turnover.”
4
Q

Bank Loans - lender influence - information

A

Contractual right to receive information about the companies’ financial condition, cash management services. Lenders enjoy important informational advantages over the board (the directors receive filtered information form the officers whenever there is a meeting (not daily).

5
Q

Bank Loans - lender influence - incentives

A

Incentives to monitor the managers? Lenders want to be repaid. Directors have weaker incentives to monitor (fiduciary duties not enforced by courts + directors have other jobs).

6
Q

Bank Loans - lender influence - expertise

A

Lenders are institutions that have specific departments – loan department dealing with the automotive industry – significant expertise about the companies that they are monitoring.

7
Q

Bank Loans - lender influence - enforcement

A

Avoid mismanagement – lenders have significant tools for enforcement, even without calling the borrower into default, they can threaten to renegotiate the contract by adding covenants to the contract that would constrain managements behaviour even more.

8
Q

Bank Loans - Typical Covenants:

A
  • Financial covenants
  • Investment constraints
  • Fundamental changes
9
Q

Bonds - Rights of Bondholders:

A
  • Contained in contract known as an “indenture”
  • Indenture trustee to mitigate collective action problem
  • Indenture contains covenants similar to bank loan agreements
  • No implied rights for bondholders
10
Q

Shareholder limited liability and shareholder – creditor agency problems

A

Upside benefit combined with limited liability give shareholders incentive to take actions that benefit shareholders but harm creditors, such as:
o Increasing the riskiness of the corporation’s business
o Siphoning of assets
o Increasing borrowing

11
Q

Creditor Protections - Healthy Companies

A

Creditors do not benefit from any fiduciary duties. The contract is going to contain the principle protections for creditors. MBCA has a provision restricting the company to pay dividends to shareholders that would render the corporation insolvent, there is also a financial statement test. There are also restrictions on fraudulent transfers (strip value of the company to the detriment of the creditors).

12
Q

Creditor Protections - Insolvent Companies

A

Insolvency is a financial concept. When a company is insolvent the director’s duties can be invoked by the creditors. Upon insolvency the creditors take the place of shareholders as residual beneficiaries of fiduciary duties – residual owners of the corporation.

13
Q

Advantages of Debt

A

o Tax benefits, cheaper than equity, leverage
o No statutory limit on amount (generally) or
need for SH approval
o No legal control rights, no fiduciary duties
o Disciplines management – reduces slack and risk-taking
o Lender monitoring and influence (?)

14
Q

Lender monitoring and influence?

A

♣ Lender influence is salutary in that the officers do have a counter weight in the lenders office.
♣ Lenders monitor to make sure that they are repaid – lender concerns do not coincide with those of the SH and lenders interest may not be in the best interest of the company.

15
Q

Disadvantages of Debt

A

o Loss of management flexibility
o Repayment obligations
o Bankruptcy risk
o Risk of creditor opportunism

16
Q

Creditor opportunism

A

Avoiding risky projects, governing the corporation in a conservative way to make sure that the company has the money to repay, even though a riskier strategy would be better for the company in the long-term. “Distress investors” such as hedge funds, private equity funds, and investment banks are opportunistic when they use debt to obtain control of a financially troubled firm and extract improper gains at the expense of the firm and its other stakeholders.

17
Q

Capital Structure – Wrap Up - Equity/Debt:

A

 How external financing reduces managerial flexibility
 The relative riskiness of equity vs. debt
 The equity “contract” and management’s power over creation of new shares
 The structure of the investment affects shareholder/lender influence
 The benefits and risks of lender influence/monitoring