Sources of financial distress, Effects of financial distress, Reorganization

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Corporate Finance FIN 622

Lesson 37

FINANCIAL DISTRESS AND FOREIGN EXCHANGE MARKET

The following topics are covered in this hand out:

Sources of financial distress

Effects of financial distress

Reorganization

We can divide the sources of financial distress into three categories:

a- Firm level causes of financial distress

b- Industry level causes

c- Macro level factors causing financial distress

a. Firm Level Causes

These factors are specific to a particular firm and include i) ownership and governance, b) operating risk

and c) leverage.

For example, agency costs connected with managerial discretion and debt, depending on the extent that

they are not mitigated through contracting devices can affect a firm's operational efficiency, leverage,

profitability and risk. However, if a firm is observed to be in financial distress, and even if the cause of the

distress can be traced explicitly to bad decisions by management, it may be difficult to distinguish whether

the decisions that contributed to distress are due to management's self-serving behavior or to

incompetence.

b. Industry Level Causes Competition:

Five forces of industry competition are useful for identifying possible industry level causes of financial

distress. These forces are 1) entry / exit barriers, 2) bargaining power of vendors 3) bargaining power of

buyer 4) threat of substitute products and 5) rivalry among competing firms.

A negative shock to an industry's product demand or costs especially if it is sustained over time, will

eventually force a shakeout of firms in the industry. The weakest firm will be forced into liquidation or

must consider being acquired by a stronger firm in the industry.

The leverage helps boost a firm's sales growth relative to that of its industry rivals because the firm commits

to aggressive competitions in the product markets, which leads less aggressive competitors to yields part of

their market share. The firm may deliberately choose low leverage so as to be able to pursue predatory

market strategies to squeeze a high-levered rival, perhaps to the point of bankruptcy.

The industry shocks contribute to the frequency of takeover and restructuring activity. Shocks include

deregulation, changes in input costs, and innovations in financing technology that induce or enable

alterations in industry structure. The inter-industry patterns in the rate of takeovers and restructurings are

directly related to the economic shocks borne by the sample industries.

Financial researchers and thinkers have investigated the effect of a bankruptcy announcement by one firm

on the values of other firms in the industry. There are two conflicting effects. On one hand, there may be

contagion effect. The market may lower the value of other firms in the industry because the bankruptcy

announcement reveals new negative information about the status of the industry as a whole. On the other

hand, the market may raise the values of other firms in the industry because on of their rival has failed.

The deregulation of an industry can induce financial distress in many firms within the industry as the

economic structure of the industry changes. Over the last decade, Pakistan has deregulated the

transportation industry (airline and rail), communication industry and several public sector giant industries

including Pakistan Steel.

c. Macro-Level Causes

Recessions create financial distress by narrowing the margin between cash flow and debt service. When the

flow constraint is relevant, a principal effect of drop in current income is the reduction of expenditure on

illiquid and long-lied assets. There are two reasons for this. First, lower current income increases the short

run probability that the flow constraint will have to be satisfied through costly means, for example, the

distress sales of assets, borrowing at unfavorable terms, sever reduction in current living standard, or as the

last resort, bankruptcy. Secondly, a drop in current income typically has ambiguous implications for the

consumers' estimates of future income flows and, hence, for the level of durables holdings consistent with

maintenance of solvency in the long run. Because durables are illiquid, it is more costly to correct an over

purchase than an under purchase. Assuming that waiting for new information will tend to resolve the

ambiguity created by the initial income fall even a risk neutral consumer will be motivated to defer durables

purchases until the uncertainty is resolved.

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Corporate Finance FIN 622

Monetary Policy: liquidity reminds us the critical role of monetary policy on the nation's overall liquidity.

The state bank affects the level of aggregate liquidity primarily through its open market operations. These

operations involve the SBP buying or selling T-bills and Govt. securities out of its considerable inventory,

to affect its intended policy to ease or tighten liquidity in the banking system. When it buys bills, an

expansionary maneuver, it adds legal reserves to the banking industry, which the nation's banks can use to

create new loans on a multiplied basis. Selling bills has the opposite or contradictory effect. Short-term

interest rates fall when the SBP is pursuing an expansionary policy, and rise when contradictory policy is

being pursued.

The primary duty of central bank is to protect the purchasing power of rupee, while also allowing for a

sustainable level of real growth in the economy. The SBP operates under the assumptions that inflation is

positively related to real economic growth. On one hand, if real economic growth is weak, the state bank

can pursue an expansionary policy without much concern about inflation.

On the other hand, when economy is overheated, state bank eventually steps in with contradictory policy to

cool the economy and thereby reduce inflation. Of course, a consequence of contradictory monetary policy

is a rise in the rates on, and tighter limits on the availability of short-term loans.

Effects of Financial Distress:

Cost associated with the entire real world factors that we have covered so far are exacerbated when a fir is

operating under financial distress.

Loss of Tax Benefit: if a levered firm fails to make profits on a chronic basis, it looses the value of the tax

shield provided by debt interest and depreciation. Depending on the firm's initial leverage and depreciation

base, these losses alone can place the firm at a competitive and strategic disadvantage.

Transaction Costs: the cost of transacting in the financial markets is much higher fro firms in financial

distress. In some cases, the capital markets may be effectively closed to a firm that is in severe distress, in

part because, given the effort required by an investment bank that float the firm's equity or debt securities,

the required underwriter spread would be prohibitively high.

Increase in Illiquidity: significant losses in the market value of a firm's equity can have several negative

liquidity effects. First, the firm may lose some professionals who play vital role is supporting the flow of

information about a stock, which is critical to liquidity. Secondly, the investors' interest in trading that stock

may reduce resulting in increase in the bid-ask spread. Third, there are chances that stock exchange may de-

list that stock, but this will depend on the regulations of stock exchange.

At this point, the firm has lost most of its potential to raise equity funds; raising debt funds will be more

difficult as well. Moreover, this may come at a time when the firm is most in need of external funds to

survive.

Capital Reconstructions:

These types of schemes can be undertaken for different purposes. We can divide them into two broad

categories;

- Scheme undertaken where company is in financial distress

- Scheme undertaken where company is not in financial crisis

However, there may be a situation, which may have characteristics of both of the above situations. A

company may heading towards financial distress and decides to go for reconstruction.

The firms in financial distress may undertake restructuring to improve both their mix of different types of

capital and the timing of availability of funds. The main objectives of reorganization may be from the

following factors. It may be a single factor or combination of several.

- To reduce the after tax cost of borrowing

- To settle the loans sooner or later

- To improve security of finance

- To improve financial image of the company

- To make company more attractive to the investors

- To cleanse balance sheet

Types of reorganization:

The following are the types of reorganizations:

- conversion of debt to equity or vice versa

- conversion of equity from one class to other

- conversion of debt from one class to another

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Corporate Finance FIN 622

FOREIGN EXCHANGE MARKET

Today, most of the businesses are not just conducting their trade in one currency. They have to trade in

more than one currency. All the currencies except the home currency are known as foreign currencies. This

is extremely large market and most of the transactions are carried out using the telecommunication

technology like telephone, email, fax etc. The main market players are central banks, banks and For-ex

(Foreign exchange) dealers conducting trade on behalf of their clients including business firm, governments.

The existence of FX market is of crucial importance in the development of international trade that requires

the use of foreign currency. FX market is very competitive as there are several buyers and sellers,

standardized procedures and regulations, commodity is homogeneous and most of the times transactions

are being carried out over the phone without physical participation. The prices of currencies are determined

by demand and supply.

Exchange rates: an exchange rate is the price of one currency in terms of another. There are two currencies

involved a base and variable. When a FX dealer quotes in terms of Pak Rs. / US $, then he is referring the

rate for the number of US $ to one Pak rupee.

For one exchange rate (Pak Rs. / US $) there are two types of rates normally quoted. That is bid and offer

rate. Bid rate is lower than the offered rate.

A dealer/bank may express PKR/US$ as 60.5500 60.5900

Bid price lower price, a price at which the dealer will sell the variable currency.

Offer price higher price, a price at which the dealer will buy the variable currency.

At 60.5500, dealer will sell US $ in exchange for PKR

At $ 60.5900 dealer will buy US $ in exchange for PKR

The difference between bid and offer prices is know as spread and represents the gross margin of the

FX dealer.

Spot Rates:

Foreign currencies can be traded on either spot or forward.

Trading spot means that the settlement will be now extended to two working days after the transaction is

made. Buying or selling forward means that settlement will be made at an agreed future date. Therefore,

there will be different rates for spot and forward for an identical pair of currencies. Forward contracts have

settlement date up to one year with exception to major currencies where it can be two years.

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