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7/29/2019 L 08 Post-Loss Financing2
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Post-loss Financing II: Liquidity and
Debt Restructuring
Lecture 8 of 16
Dr. Tahir Khan DurraniCEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD
A Meditation For The Week:
“The tools of learning are the same for any and every subject; and the person who
knows how to use them will at any age, get the mastery of a new subject in half
the time and with a quarter of the effort expended by the person who had not the
tools at his command.” Dorothy L Sayers (1893-1957)
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Topic Objectives
Review Capital structure andliquidity Issues
Review the limitations of
post-loss financing
Further develop thefundability issue
Focus on dividend policy
under uncertainty
Assess the impact of liquiditycrunches and implications of
debt restructuring.
Dr. Tahir Khan Durrani 2
“There is nothing so easy but it becomes
difficult when you do it with reluctance.”
Terence (2nd Cent. BC)
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Information Asymmetry: The PeckingOrder Hypothesis
Insiders may havebetter informationabout what ishappening within afirm and maytherefore be able toforecast futureearnings more
accurately. Outsiders do not have
access to insideinformation.
With optimistic inside
information, there
would be ranking of
ways of financing theinvestment:
first inside funds
new debt, and
new equity
Dr. Tahir Khan Durrani 3
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Information Asymmetry: The PeckingOrder Hypothesis
If insiders issue new equity, its likely that
insiders have low expectations of future
earnings.
Insiders would not wish to share the
promise of good news with new
investors and any attempt to issue newshares is perceived as a bad signal.
Dr. Tahir Khan Durrani 4
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The Ordering of Financing
Internal funding is the most desirable Debt financing is the next best
Hybrid financing (e.g. Convertible bonds)
comes next Equity financing is least desirable.
Note: This theory should be used in conjunctionwith cost of financial distress hypothesis(favours equity) and the tax reasoning (favoursdebt).
Dr. Tahir Khan Durrani 5
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The Pecking Order Hypothesis and Post –loss financing
What sort of peculiar information asymmetryproblems are we likely to be faced with following
some risky event.
Losses from currency fluctuations are fairly transparent.
Liability suit is encumbered with a lot of private information,
making it difficult to forecast the impact on profitability.
Losses from a terrorist attack fall in both categories.
Events imperfectly observed and appraised by
outsiders are more costly to finance externally.
Dr. Tahir Khan Durrani 6
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Liquidity Problems and Post-LossFinancing.
Firms finds it difficult to raise new funds, if the loss is severe and the firm is alreadyhighly levered.
There will be an underinvestment problem,as shareholders are not willing to shore upold debt.
Large losses may also widen the information
gap between insiders and potential newinvestors.
Some losses do exhaust liquidity.
Dr. Tahir Khan Durrani 7
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Liquidity Headaches, New Investmentand Dividend Policy.
Formulas for the post-loss value of the originalequity before and after loss, assuming no default risk are:
V(E) = V0
+ L – K t
+ Vt
– D –T (pre-loss)
V'(E) = -C + V'0 + L – K't + V't – D –T‘ (post -loss)
Firm needs C to pay for losses and has cash L.
If L < C, the firm is forced to consider new debt or equityor give up some post-loss investment projects.
Even if L > C, a change in dividend policy might berequired.
Dr. Tahir Khan Durrani 8
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Information content of Changes inDividend Policy
M&M asserts that dividend payouts are irrelevant,but traditionalists favour high dividends.
Would payment in losses, by varying dividends
have any effect on the value of the firm?
Losses are random so they carry no information about
future earnings.
What will be the effect if they are scrambled together
with short-term changes affecting long-run earnings?
Is it possible to isolate noise from signals of changes in
the long-run value?
Dr. Tahir Khan Durrani 9
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Informative and UninformativeEvents
Informative events are those risky eventsthat influence future earningsexpectations.
Uninformative events are those that do not influence expectation of future earnings.
The separation is important because
information carried by a risky event is animportant factor in deciding post-lossinvestment and financing.
Dr. Tahir Khan Durrani 10
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Informative and UninformativeEvents
Earnings in the current year are described by N1,with N1as some base level, distributed by somerisky events: m, which is informative, and u, whichis uninformative:
N1 = N1 + m + u,
Suppose that if we knew m, we could forecast expected earnings next year as follows:
E(N2) = N1 + am
Where ‘a’ is some parameter that reflect the degreeof information carried by m.
Dr. Tahir Khan Durrani 11
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Informative and Uninformative Events
E(N2) does not depend on ‘u’ because it isuninformative and transitory.
Insiders know the composition of earnings, they
know N1, m, and u.
Outsiders only observe N1, so they must make
informed guess as follows:
E(N2) = N1 + aE(m|N1) Where E(m|N1)is the outsider’s conjecture of the
expected value of m, based on having observed previous
period earnings, N1.
Dr. Tahir Khan Durrani 12
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Separating Equilibrium Theorem
Outsiders are likely to underestimate next year’searnings if ‘m’, turns out to be high, and overstate if ‘m’ turns out to be low.
Paying a high dividend might send a credible signal,
but it imposes a higher cost. Its difficult for a company with a low ‘m’ to send
such a signal, because:
Lower ‘m’ signifies lower earnings
Future earnings will most likely be lower than expectedand consequently revaluation of the stock price.
Sending false signals can result in civil action (e.g.ENRON)
Dr. Tahir Khan Durrani 13
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Risk Management Strategy: Smooth CashFlows from Transient Events
Negatively informative shocks Deplete current earnings and also leads to revision
of future earnings expectations.
If a separating equilibrium exists, mgt will be
better off reducing dividends and moderatingfuture investor expectations.
Associated with downward revision in expectedfuture earnings and the payback from post-lossinvestment can be adversely affected.
Little need to raise money either to maintaindividends or fund investments (low NPV).
Dr. Tahir Khan Durrani 14
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Risk Management Strategy: Smooth CashFlows from Transient Events
Positively Informative Shocks: Carry good news about the future.
Catastrophic events in insurance deplete capacity
to write new business, but there is usually a shift to the right in the demand curve, increasing the
prices, and future profitability.
There is need for post-loss financing both to
maintain dividends and to capture the attractivepost-loss investment opportunities.
Dr. Tahir Khan Durrani 15
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Risk Management Strategy: Smooth CashFlows from Transient Events
Uninformative (transient) shocks: Carry no adverse information about future earnings.
Generates a demand for post-loss financing to maintain the
level of dividends, post-loss investment and reinvestment
opportunities.
Do not dampen the need for new money for post-loss
investment, since the payback to new investment is
unaffected.
Smoothing is important for events that are uninformativeor carry positive information about future earnings, and the
reverse is true for risky events that carry negative
information.
Dr. Tahir Khan Durrani 16
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Liquidity Crunches
Suppose, the value V, ismade up of both assets
that are tangible and
liquid, L, and assets that
are intangible (V-L). The intangible asset is
the growth potential.
Suppose debt is due.
The firm has a problem;
how to repay the debt.
Dr. Tahir Khan Durrani 17
Value of
Claim
Value of
FirmL D V
E
DDebt
EquityBankruptcy
Costs
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Liquidity Crunches
Figure shows the value of debt and equity for
given potential values of the firm. If the firm’svalue exceeds its debt obligation, D, the equityhas positive value. Thus, at value, V, the value of the debt is apparently its full face value, D, andthe equity is worth E ( = V
–D ).
Suppose that the value , is made up of bothassets that are tangible and liquid, L, and assets
that are intangible, V –L.
The tangible assets could include cash,securities, and other assets that could be soldquite quickly.
Dr. Tahir Khan Durrani 18
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Liquidity Crunches
The intangible asset is the growthpotential.
Furthermore, suppose that the debt is
due. The firm has a problem: how to repay the
debt. The intangible asset cannot easily
be sold to realize its value and make goodthe debt payment.
The firm has a liquidity problem.Dr. Tahir Khan Durrani 19
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Liquidity Crunches
Liquidity problem can be more immediate.
This issue may be that the firm is havingtrouble finding enough cash to pay interest.
To avoid bankruptcy court, the firm can sell off
some tangible asset to make the interest payment. But this will have an opportunity
cost.
When an asset is sold, the return on that asset is lost.
Dr. Tahir Khan Durrani 20
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Liquidity Crunches
Another type of liquidity problem is that thefirm has some cash and can meet its debt
obligations.
However, if there is some immediate claim onthat cash to cover unhedged loss, and external
financing is costly, the firm may lose some
future investment opportunity;
this is the crowding out hypothesis.
Unhedged losses can bring about any of the
above liquidity problems.Dr. Tahir Khan Durrani 21
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Liquidity and Bankruptcy
The intangible assets cannot easily be sold to realiseits value and make good the debt payment.
There is an opportunity cost in selling some of the
tangible assets. the return on that asset is lost.
If there is some immediate claim on the cash to cover
unhedged loss and external financing is costly, thefirm may lose some future investment opportunity.
Dr. Tahir Khan Durrani 22
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Renegotiations of Debt andPost-Loss Underinvestment
Earlier we show that the post-loss value of equitywhen the firm paid an amount C to reconstruct a
damaged asset as:
V'(E) = -C + V'0 + L – K't + V't – D –T‘
Assume L and T‘ are zero, and there are no
investment opportunities, Kt and Vt are also zero
V0 = V0N‘ + V0'
V0 is the PV of earnings, assuming the asset is not repaired(V0
N‘ ), plus the change in value from reinvestment (V0').
The firm has limited liability
Equity can not have –ve value
Dr. Tahir Khan Durrani 23
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Renegotiations of Debt andPost-Loss Underinvestment
V(E) = Max[(V0N‘ – D + V0‘- C);0]= Max[(V0
N‘ – D + NPV);0]
[NPV = V0‘- C (NPV of reinvestment)]
If there is no reinvestment the equation simplifies to
V(E) = Max[(V0N‘ – D);0]
If V0‘> C then NPV is positive
What if NPV from reinvestment is positive, but V0N‘ < D? The NPV from reinvestment is enough to prop the debt,
but is reinvestment worthwhile to shareholders.
Dr. Tahir Khan Durrani 24
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Renegotiations of Debt andPost-Loss Underinvestment
Shareholders gain if V0
N‘ – D + NPV > 0,
hence supports
reinvestment. Shareholders lose if
V0N‘ – D + NPV < 0,
as all reinvestment benefits accrue to
creditors.
Dr. Tahir Khan Durrani 25
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Renegotiations of Debt andPost-Loss Underinvestment
Reinvestment through bankruptcy when there is not enough value to persuade new investors.
Reinvestment through debt renegotiation:
Creditors gain from reinvestment, so they have to offer
something to shareholders to make it attractive to
reinvest, without declaring bankruptcy and incurring
bankruptcy costs.
The gain from debt renegotiation depends on the
bargaining power of the creditors and originalshareholders.
The greater the ownership negotiated by creditors, the
greater their gain.
Dr. Tahir Khan Durrani 26
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Debt Renegotiation: A Case for Energis
Energis
Entropy
Dr. Tahir Khan Durrani 27
i id l d i
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Energis Losses Widen As Slowdown BitesFT.com; Nov 13, 2001, BY BEN HUNT IN LONDON
Energis, the UK telecoms group spun out of the National Grid,
said its first-half performance had held up well despite toughmarket conditions that had caused a slowdown in sales growth.Although sales in the six months to September 30 rose to£488m, up 33 per cent on £368m last time, it reported a sharpfall in growth from the second half of fiscal 2001, when it recorded sales of £472.5m.
David Wickham, chief executive, said many of its customers hadresponded to difficult economic conditions by cutting back investment and focusing on cost-saving measures." Ascustomers have adjusted to economic slowdown we have seenan overall lengthening of the time taken to confirm orders. Wehave also witnessed a slowdown in the growth of usage of telecoms by some customers, and in a few cases, a reductionreflecting their levels of trading activity," he said.
Mr Wickham said Energis had repositioned itself to reflect market conditions and the changing order cycle and hadincreased its pipeline of tender order to about £430m, including£48m in new tenders since the end of September.
Dr. Tahir Khan Durrani 28
i id A Sl d i
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Energis Losses Widen As Slowdown BitesFT.com; Nov 13, 2001, BY BEN HUNT IN LONDON
Energis recorded a first-half pre-tax loss of £96.7m,against a £45m loss last time, and a loss per share of 2.7p (5.5p).
Earnings before interest, tax, depreciation andamortisation increased from £65m last year to £73.7m,
but showed a fall on the previous six months (£75m). The group said it would continue to improve
profitability through stripping costs out of the business.It said a further reduction in headcount by 350 wouldbe added to the 100 jobs it had already cut as it
attempted to shave £20m from operating costs. The group has also reduced capital expenditure for the
year by £60m to £34m.
Energis shares were 1.22 per cent, or 1p, higher at 83p
during early Tuesday trade in London. Dr. Tahir Khan Durrani 29
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Energis Close To Collapse: Telecoms Network Abandons OverseasOperation …
The Guardian; Feb 22, 2002 (RICHARD WRAY)
In the bright days of 1997, Energis floated out of National Grid.
Now, its shares next to worthless, it is back where it started,sending messages down power lines, the telecoms network once worth £12bn, yesterday experienced a dramatic fall fromgrace as it abandoned its £1bn continental European network,slashed 400 UK jobs and started desperate negotiations with
bankers and bondholders to stave off complete collapse. The company is in such a hole that its mainland European
investments could be sold for just £1. At the end of the dayEnergis was worth just £65m as bond dealers calculated that they could end up holding the vast majority of the firm's almost worthless shares. "Whatever happens from now on, this hasbeen a disaster for shareholders," said one analyst.
The cruellest blow for Energis came when National Grid, stillthe company's biggest shareholder with a 33% stake, told theEnergis board that it will not bail them out.
Dr. Tahir Khan Durrani 30
E i Cl T C ll T l N t k
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Energis Close To Collapse: Telecoms Network Abandons Overseas Operation … The Guardian; Feb 22, 2002 (RICHARD WRAY)
The telecoms company was forced to announcea strategic review last month after a profitswarning which caught the market completely bysurprise.
But the future of Energis, which is £1.2bn indebt, rests in the hands of the banks whichsigned off a £725m credit facility late last yearand holders of £550m worth of its corporatebonds.
It is already using £605m of its credit facilityand is set to breach crucial conditions attachedto the loan because of the drop in demand fortelecom services from corporate customers,which has hit earnings.
Dr. Tahir Khan Durrani 31
E i Cl T C ll T l
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Energis Close To Collapse: TelecomsNetwork Abandons Overseas Operation …
The Guardian; Feb 22, 2002 (RICHARD WRAY)
Energis also announced that it will have to
restructure its £550m worth of corporate
bonds because its banks only want their money
used to support the UK business rather than
Energis' London-listed holding company.
It is the listed plc business that issued the
bonds and must pay the semi-annual "coupon"payment to bond holders.
Dr. Tahir Khan Durrani 32
E i Cl T C ll T l N t k
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Energis Close To Collapse: Telecoms Network Abandons Overseas Operation … The Guardian; Feb 22, 2002 (RICHARD WRAY)
The next payment to bondholders is due onMarch 15 when Energis will have to pay £13mto £15m; a similar amount is due again in June.
"My expectation is that the bonds will get exchanged for equity and bondholders will endup holding 75% to 80% of this company," saidan Energis bondholder last night. “
The problem is that a lot of bond holders willbe forced sellers, so the stock today iseffectively worth nothing."
Dr. Tahir Khan Durrani 33
Energis Entropy
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Energis Entropy The Guardian - Feb 22, 2002
Shares in Energis dropped more than 60 per cent in value after it
confirmed that it would breach its banking covenants andannounced restructuring plans, including selling its loss makingoverseas businesses to raise cash.
The shares lost more than 62 per cent, hitting a low of 5p, whilethe company's bonds fell to a third of their face value.
It had admitted weeks ago that key financial projections, uponwhich its new banking facilities of just a month earlier werebased, were wrong. At that point "ownership" of the companypassed from shareholders to its lenders, the banks and bondholders.
The business was going to be repossessed. In simplistic terms, allthat remained was for the assets to be assessed for their viabilityand then valued. Any one trying to deal in the company's pennyshares before yesterday's wipe- out was simply having a wild bet that there might be just a little something left at the end of the dayonce everyone else had been paid their money back.
Dr. Tahir Khan Durrani 34
E i E t
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Energis Entropy The Guardian - Feb 22, 2002
Energis's banks are now at war with bondholders. It is inevitable that since the banks will not let any of their cash go to paying off bondholders, the onlyrealistic option now for the latter class of creditor isa debt-for-equity swap, turning their bonds intoshares and hoping that a viable business emergessomewhere down the line - the first substantialexample of which we will have seen in Britain for agood seven or eight years.
This attempted corporate workout will be long and
acrimonious, but it is likely to be smoother than thecrop of similar exercises undertaken during the last recession, when the rules of the so-called LondonApproach were being made up as bankers andstricken management limped along.
Dr. Tahir Khan Durrani 35
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Learning Outcomes Reviewed the use post-loss financing in smoothing
earnings and addressing liquidity crunches.
Developed a thorough understanding of problemsassociated with prior debt.
Developed an understanding of Post-loss companyrestructuring and debt renegotiation.
Paved way for the discussion of our next lectures,contingent financing and hedging.