Question

Subject : Corporate Finance Theory

Please provide me answers with details that is based on the corporate finance theories

• Question do not require a quantitative analysis or a numerical example

Answer the following two questions: With debtor in possession (DIP) financing, the bankrupt firm can obtain additional amounts of debt senior to the firm’s existing debt. Explain how the firm’s existing debtholders can benefit from this. Would debtholder-equityholder conflicts be more severe for firms that borrow short term than long term? Explain why.

Answer 1

Debtor-in-possession (DIP) financing is a special kind of financing meant for companies that are in bankruptcy. Only companies that have filed for bankruptcy protection under Chapter 11 are allowed to access DIP financing, which usually happens at the start of a filing. DIP financing is used to facilitate the reorganization of a debtor-in-possession (the status of a company that has filed for bankruptcy) by allowing it to raise capital to fund its operations as its bankruptcy case runs its course. DIP financing is unique from other financing methods in that it usually has priority over existing debt, equity, and other claims.

It is beneficial to the existing debt holders in way such that they the company under DIP would receive additional loan. However, Once a company enters in Chapter 11 bankruptcy and finds a willing lender, it must obtain approval from bankruptcy court to secure lending. Providing a loan under bankruptcy law provides a lender with much-needed comfort in providing financing to a company in financial distress.Thus the company can continue its operations and reorganize and eventually payoff all its debts including existing debts.

Conflict between debt holder and equity holder is believed to be based upon the size of the firm: Below reasons explains why there could be worse conflicts:-

1. Small firms are generally more flexible in their daily operations and managing capital requirements. They are usually in command to increase the risk by going for debt funding, and here comes the conflict part. The debt funding Organization (lender) would want to place someone on the board of the borrower to influence the decision making process which is not generally appreciated by firms's management and conflict begins.
2. Top managers, directors and their relatives are generally major shareholders in small firm which gives them greater incentives to make choices to benefit equity holders at the expenses of the debt holders..
3. Although, a small firm is expected to have lower debt ratio, however in reality that is no where close. This is driven by aspiration to become large, a small firm borrows more and end up having a lender person on board which results in deep conflicts.
4. Long-term debt is most likely a convertible debt, which after a certain period can be converted into equity. Therefore a lender who is going to be shareholder of the firm wouldn't take part in activities which are detrimental to the interest of the firm which means no or negligible conflict.
5. Long-term debts however comes at a higher transaction cost and generally small firm don't prefer to move that motion.