Question

Consider a firm in financial distress (i.e. its assets are worth much less than the face amount of its outstanding debt, which is due in two years).

For each scenario below, please briefly explain who stands to gain and who stands to lose among the firm’s owners? Focus on the incremental gain or loss in value for each party that each scenario may entail.

1. The company manages to scrape together cash and distributes it as dividends

2. The lenders accept to extend the maturity of their loans by one year

3. The company invests in a negative-NPV project using the remaining cash

4. The company raises money by issuing preferred stock and invests it in a new project with a

   positive NPV

5. The company invests in a new project with a zero-NPV and raises debt to finance it; the new

   debt has exactly the same level of seniority and security as the existing debt

6. The company ceases operations, sells its fixed assets for an amount that is much less than the

   face amount of debt and invests the proceeds in treasuries

Answer 1

The company manages to scrape together cash and distributes it as dividends

• Stockholders or shareholders stand to gain because they got back a part of their invested capital in a situation when they would have otherwise got nothing.
• Bondholders stand to lose as the value of the bond falls as the value of assets securing the bond has fallen.

The lenders accept to extend the maturity of their loans by one year

• Bondholders stand to lose, as their capital remains unpaid for one more year. Their risk has thus increased.
• Stockholders stand to gain, as there is now no risk of default for the next one year.

The company invests in a negative-NPV project using the remaining cash

• Both stockholders and shareholders stand to lose. The negative NPV project will erode the value of the firm, for both the owners.

The company raises money by issuing preferred stock and invests it in a new project with a positive NPV

• Both stockholders and shareholders stand to gain. The positive NPV project will enhance the value of the firm, for both the owners.

The company invests in a new project with a zero-NPV and raises debt to finance it; the new debt has exactly the same level of seniority and security as the existing debt

• The bondholders stand to lose. The firm adds assets as well as a debt of equal amount. This would increase the debt ratio of the firm, leaving the old bondholders more exposed.
• The stockholders will stand to gain. This is because what the old bondholders lose, is the stockholders’ gain.

The company ceases operations, sells its fixed assets for an amount that is much less than the face amount of debt and invests the proceeds in treasuries.

• The bond holders stand o gain. They are sure to get the principal sum as well as interest on the same.
• The stockholders stand to lose. They know that the invested amount will never grow to an amount that will be sufficient to retire the debt of the firm.