Behavioral Finance #
Managers are less than fully rational
Roll’s theory of acquisition
- Acquirers may be optimisitic and overconfident in their own valuation of deal synergies and fail to properly account for the winner’s curse
- The winner’s curse: Who wins the auction may be the one who overestimates it most
Malmendier and Tate’s option-based proxy for overconfidence
- Overconfident CEOs do not exercise their options even when they are in the money - it is guaranteed to make a great profit from their options
- They complete more mergers, especially diversifying mergers, which are typically suggested as being of dubious value
- Investors are more skeptical about bid announcements when they are made by overconfident CEOs
Hackbarth found positive relationship between overconfidence and level of debt
Overoptimism #
- Usually modeled as overestimation of an outcome - overestimating the probability of a good outcome or underestimating a bad outcome
- Financial executives exhibit overoptimism
- Both optimism and overconfidence are associated with higher investment
- Entrepreneurs tend to be overoptimistic about their future success - yet not a bad thing, just come with costs
- Overconfidence and overoptimism have obvious costs, but they can also help shareholders by encouraging risk-averse managers to take good risky or innovative projects
Financial Distress Basics #
Conceptual #
A situation where a firm’s operating cash flows are insufficient to satisfy current obligations and the firm is forced to take corrective action
Financial distress may lead to firms to default on a contract, and involve financial restructuring - then do corrective actions
Insolvencies #
Stock-based: The value of the firm’s assets is less then the value of debt - causing negative value of equity
Flow-based: The firm’s cash flows are insufficient to cover contractually requierd payments
Investment distortions during financial distress #
Excessive risk taking (asset substitution)
- Shareholders have unlimited upside potential yet bounded loss, and in financial distress, they knew they are possibly not repayed, so they are tempted to gain by gambling (negative NPV projects) at the expense of debtholders
Debt over-hang(underinvestment)
- In financial distress, as managers care about their own compensation package (as part of agency issue), they may prefer to pay out cash to shareholders in the form of a dividnd than fund projects (even positive NPV projects) as most of the profit would go to the firm’s existing creditos, and of course existing shareholders will reject this as their interests are diluted
- New shareholders will not buy equityat existing prices but require a substantial discount
Financial Distress Outcomes #
Financial distress does not usually result in firm’s death, as firms deal with distress by seeking external fundings, cutting expenses, negotiating with banks and other creditors and eventually filing for bankruptcy
Australia’s trend on bankruptcy #
Changing towards the US, a debtor in possesion model, i.e. seeking to repay the creditors while the origianl managements running the business as usual
Bankruptcy Liquidation and Reorganization #
Firms either liquidate or reorganize if they cannot meet their obligation
Choices
- Liquidation: Termination of a firm, selling its seets for salvage value and distribute the proceeds to creditors
- Reorganization: Keeping the firm going, may involve issuing new securities and selling assets to repay debt
- Typically depends on the judgement which way worths more
Liquidation procedure #
- A firm may voluntarily file a petiiton, or its creditors file for it
- A court(or creditor) appointed administrator attempts to liquidate the assets
- The proceeds of liquidation (minus the administration costs) are distributed to the creditors
- If any proceeds remain after expenses and distribution to creditors, they are distributed to the shareholders
Absolute priority rule (APR) #
- Proceeds are distributed as per the absolute priority rule
- Secured creditors are paid from sale of the security (typically property) and are outside the priority list
- If insufficient proceeds, they join other unsecured creditors in dividing up the remaining value
- APRs are frequently violated - distribution of preceeds in a bankruptcy are typically subject to negotiation
Predicting Corporate Bankruptcy: The Z-Score Model #
Formula omitted for cleaness
- Provides a quick, objective way to evaluate creditworthiness
- Australian version not obtained, possibly due to lack of samples