Week 3- Chapter 11
Week 3- Chapter 11 Fin 4310
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BUSN 1301 - 006
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This 5 page Class Notes was uploaded by Laura Notetaker on Sunday September 13, 2015. The Class Notes belongs to Fin 4310 at University of Texas at El Paso taught by Dr. Oscar Varela in Summer 2015. Since its upload, it has received 63 views. For similar materials see Managerial Finance in Finance at University of Texas at El Paso.
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Date Created: 09/13/15
Week 3Chapter 11 When you decide to invest this is a decision that should not be taken lightly Once you invested there is always the possibility that the person may choose to abandon or sell his investment this is call to exercise a put option on an investment The option to expand a business is a call option on the expansion and an abandon of a project is a put option on the project If the cost of liquidation in period is less than the EVNPV for the project based on a preabandonment distribution then the project should be abandoned To make a relevant analysis you need to obtain for each of the two possible outcomes the PV The weighted average of the discounted values of the remaining end of period two cash flows You are always look for the possible outcome where you can gain more money This calculation is used with the riskfree discount rate The value of abandonment is the difference between the EVNPV using the new cash flow pattern and the original cash flow pattern The BlackScholes value call option formula Co S Nd1 K e39RfT Nd2 S is the present value at time 0 of the cash slows that remain after the abandonment after year 1 K is the abandonment value at the point in time when the project can be abandoned Rfis the current 1year riskfree rate Nd1 and Nd2 are the cumulative probabilities T is the time when the option expires in years d1 lnS K Rf12 52 T o T 2 and d2 d1 o T12 This formula determines the values of d1 and d2 This model provides values for a call option But abandoning a project is the exercise of a put option The putcall parity as the put value is five that of a call option can be obtain PoCoSKe39RfT P0 is the time period 0 value of the abandoning of a put option Week 3Chapter 11 Bankruptcy is the ultimate forced abandonment decision A firm that is bankrupt doesn t mean that it will stop from continuing its operations Some of the reasons for bankruptcy are Economic reasons recessionary period such as 20082009 worldwide financial crisis Financial reasons High risk strategies with high financial leverage high debt Natural disasters floods hurricanes tsunamis and earthquakes Examples include Katrina 2005 Sandy 2012 Corruption in the management of a firm Enron 2001 Companies that have debt have an option to buy their bonds when they are due Stock can be valued as a call option on the company s assets with debt as the exercise price The firm will exercise this option when the value of the companies is greater than the value of the debt The firm may not exercise this option if the company is worth less than the value of debt In other words bankruptcy could be the failure of a firm to exercise its option to buy back its debt When the assets are worth less than its debts the call option is out of the money which means that logical that the firm will not exercise the option and they would declare bankruptcy They should let the option expire Formal bankruptcy occurs when a firm ask for a petition of a bankruptcy court to declare themselves in bankruptcy The formal preceding is when management petitions for a bankruptcy The informal preceding is when the firm and its creditors try to settle debts outofcourt The creditors will agree to make an extension to pay the loan or a composition of a loan the firms pays a fraction of the debt The informal liquidation an assignment is entered into the firm has a trustee assigned to sell and liquidate its assets The benefits The informal proceeding Less expensive than a formal one Formal bankruptcy might absorb 20 to 30 of the firm s value in paying those administering the bankruptcy including legal feed If there are too many problems with informal proceeding the formal proceedings could be the best way to go With cross default provisions creditors can accelerate claims that may lead into an informal proceeding that aims to being first to be paid Creditors that are the last on the line they might not receive anything because the first collectors were paid first quotCommon pool problems Problems with this is that a firm may have been better off reorganizing their capital structure may be forced to liquidate their assets to pay off claims before they run out of assets Week 3Chapter 11 A formal way is to do it is the firm should declare bankruptcy by a court which will prevent the firm to sell their assets until the court can determine how to treat the bankruptcy There might be creditors who look at the common pool problem quite different and instead holdout This is when creditors agree to settle with the firm for less than 100 on their claims because of the fear that they may receive much less In this case the firm may have enough funds remaining after the initial settlements to pay those creditor who holdout in full A holdout may be difficult depending on the length of the holdout A formal proceeding would address this problem by having a court force a cramdown Where creditors accept settlements without choice and without an ability to holdout Reorganization Goes with the capital structure where there is a new value on the books and a new mixture of debt and equity against its new value The aim of reorganization is to capitalize the firm at a value that is realistic and to distribute the firm s new capitalization in an equitable manner Reorganization should have more equity and less debt to reduce financial leverage It is also the recognition that the firm is worth more alive than dead and deserves to survive and continue to operate Reorganization should be Fair Feasible If the firm know that it will go bankrupt in the future the firm would choose to liquidate rather than reorganize I Liquidation is for a firm that is selling its assets and is becoming a quotshel corporation that only has cash in its assets and uses that money to settle its debts it might have This is the case where the firm is worth more dead than alive There are certain priorities that a company need to consider Past due Property Taxes Secured creditors Trustee s administrative costs Expenses incurred after case begins but before trustee appointed Wages due workers within 3 months prior to filing Week 3Chapter 11 Unpaid contributions to employee benefit plans that should have been paid within 6 months prior to filing Unsecured claims for customer deposits Taxes due Unfunded pension plan liabilities General unsecured creditors Preferred stockholders Common stockholders Prepackaged bankruptcy is used to use the best feature of informal and formal bankruptcy proceedings Problems with informal proceedings Common pool Holdout problems They are less costly than the 30 of assets that most formal proceedings require Problems with formal proceedings Automatic stays Cramdowns Prepackaged bankruptcy uses informal proceedings up to whre the parties have the some understandings on how to handle the bankruptcy Then it uses the formal proceedings to have a imprimatur of a court to make sure that the agreements will be kept There should be a lot of cooperation between the firms and its creditors Week 3Chapter 11
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