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)



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)



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




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.




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).




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.




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.




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.




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?




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.




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.




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.




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)




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).





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.





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.




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.


Value of

Claim

Value of

FirmL D V

E

DDebt

EquityBankruptcy

Costs



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.




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



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.




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



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.




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





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.





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.





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.




Debt Renegotiation: A Case for Energis

Energis

Entropy


i id l d i



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.


i id A Sl d i



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



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.


E i Cl T C ll T l N t k



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.


E i Cl T C ll T l



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.


E i Cl T C ll T l N t k



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."


Energis Entropy



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.


E i E t



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.




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.

L 08 Post-Loss Financing2

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