Question

1. In financial distress, firms may make sub-optimal investment decisions. Explain the rationale behind this statement.
2. What are the direct and indirect costs of bankruptcy?  Give examples of firms with high and low bankruptcy costs and explain.
3. “Stockholders need not be concerned with bankruptcy costs since they will be borne by bondholders.”  Comment. (Assume that the firm declares bankruptcy when the value of assets is less than the value of obligations to bondholders.  Thus, in bankruptcy, equity has zero value.)
4. “Stock prices fall when firms issue new shares because of the dilution of existing shareholders’ position.” Comment.
5. "A firm should not pay a dividend if it can reinvest the money in new projects at a profitable rate.  Otherwise, shareholders will lose the value of the foregone projects." Comment.

Answer 1

Sub-optimal investment significantly influences company performance. There are two types of sub-optimal investment: over -investment and under investment. There are four different reasons for these problems: debt overhang, risk avoidance, risk shifting, and empire building. Each is the consequence of agency conflict between either shareholders and managers or shareholders and debt holders.

The direct costs of bankruptcy are costs that result in the filing of bankruptcy for a business. The business would need to liquidate assets, and they would incur costs such as legal costs, accounting costs, and loss of tax benefits. The indirect costs are costs that are associated with distress. These types of costs are costs that hurt the business based on filing the bankruptcy and the affects such as loss of creditors, loss of employees, loss of lending from lenders, and the loss of trust with customers.

the statement is not correct, in case of bankruptcy if the value of assets are less than the value of obligations then the liability of bond holders will be settled in proportion of the holding out of the assets, and stock holders will get any value but they get balance of assets over and above the obligation of bond holders.

the stock prices will not necessarily fall on issue of new prices, but fall on issue of bonus shares or on the event of stock split, if share prices are issued for same price as prevailing in the market then there would be no change in price, but if issued less that market price then value per share falls.

Yes, if the firm can earn higher rate of return the the market return then it is advisable to issue no dividend and invest the funds in the project and earn higher rate of return which is more beneficial to share holders that issuing dividend where investor earns lower rate of return by re investing the funds received