Summary Financial Distress and Corporate Restructuring
Lecture 1
Basic terminology
Economic distress: firms generating low or negative operating income and/or have problematic
business model
Financial distress: a company is unable to generate enough revenue to meet financial obligations.
o Economic distress is frequently leading to financial distress
o Bankruptcy is often used as an empirical indicator of financial distress
Typically, economic and financial distress occur simultaneously (but they are different concepts!)
Insolvency
Technical insolvency: a firm is unable to meet it debt as they come due
Balance sheet insolvency: total liabilities exceed value of assets (real net firm worth is negative)
Default: a borrower violates an agreement with creditor as specified in the contract with the lender
- Technical default: borrower violates a provision other than a scheduled payment
- Formal default: borrower misses interest or principle payment
Bankruptcy: a firm enters a court-supervised bankruptcy procedure
Basis terminology – restructuring (for this course we mainly focus on equity and liability side)
The value of conceptual understanding
A basic financial problem.
- Assume that the current market interest rate for lending or depositing is 10%
- What is the value of 100 EUR in one year?
- How much is a payment of 100 EUR in one year worth today?
-------
What is happening here conceptually?
The present value concept
In finance, we see the world from the perspective of cash-flows
We frequently assume no-arbitrage
We try to determine the value of those cash-flows under different circumstances (time, risk and/or
state of the economy) > we adjust the value of cash flows (discount rates)
,The present value of a perpetuity
A perpetuity is a stream of cash-flows until infinity
A (simple) stochastic model for finance
Stock return modelling
Stock returns can be seen as random variables
Random variables have a probability distribution
o Discrete random variables (e.g., throwing a dice)
o Continuous random variables (e.g., stock return)
Random variables can be characterized using statistical measures
o Expected value (e.g., expected value of throwing a dice is 3.5; estimate is sample average
o Standard deviation (volatility) – amount of variation or dispersion of a set of values (e.g.,
stock return has standard deviation of 0.1)
Different values of the standard deviation Normal distribution
Basic security pricing theory
Standard finance theory: discount future cash-flows with a discount factor
Example:
o Discounted cash flow method
o Gordon growth model (pricing stocks)
The reason why we use a discount factor is that future payments from a security/firm are
uncertain/risky (otherwise, we use the risk-free rate as a discount factor) > discount rate
components: time-value + risk-correction (see e.g., CAPM)
, Mathematically, we think about future cash-flows as random variables that have a probability
distribution
Example: stock price as sum of all future dividend payments:
Here, dividends are random variables, each dividend has
its own probability distribution
Many simplifications are typically made in finance applications for stocks.
Constant discount rate (e.g., WACC)
Do not specify probability distribution, but take expectations
Examples:
- Constant dividend (growth) in Gordon Growth model
- DCF free cash-flows do not have a probability distribution
Textbooks typically provide (mathematically) correct formulates, e.g., CAPM:
Returns themselves are random variables
However, advanced equity pricing models (e.g., Merton model), option pricing models, and credit
risk models do typically not make these simplifications > specify time-series behavior (probability
distribution) of cash-flows
Example:
- Yield curve > different risk-free rate for different time horizons
- Binominal tree for call option price > approximate probability distribution
- Credit risk literature > distinguish default and non-default state.
How to price any asset?
What is the price of this security?
A simple stochastic model (stock)
Assume an all equity firm with only one stock
Aster one time-period, the equity value will be either 0 with 10% probability or 110 with 90%
probability
The discount rate is 10%
Lecture 1
Basic terminology
Economic distress: firms generating low or negative operating income and/or have problematic
business model
Financial distress: a company is unable to generate enough revenue to meet financial obligations.
o Economic distress is frequently leading to financial distress
o Bankruptcy is often used as an empirical indicator of financial distress
Typically, economic and financial distress occur simultaneously (but they are different concepts!)
Insolvency
Technical insolvency: a firm is unable to meet it debt as they come due
Balance sheet insolvency: total liabilities exceed value of assets (real net firm worth is negative)
Default: a borrower violates an agreement with creditor as specified in the contract with the lender
- Technical default: borrower violates a provision other than a scheduled payment
- Formal default: borrower misses interest or principle payment
Bankruptcy: a firm enters a court-supervised bankruptcy procedure
Basis terminology – restructuring (for this course we mainly focus on equity and liability side)
The value of conceptual understanding
A basic financial problem.
- Assume that the current market interest rate for lending or depositing is 10%
- What is the value of 100 EUR in one year?
- How much is a payment of 100 EUR in one year worth today?
-------
What is happening here conceptually?
The present value concept
In finance, we see the world from the perspective of cash-flows
We frequently assume no-arbitrage
We try to determine the value of those cash-flows under different circumstances (time, risk and/or
state of the economy) > we adjust the value of cash flows (discount rates)
,The present value of a perpetuity
A perpetuity is a stream of cash-flows until infinity
A (simple) stochastic model for finance
Stock return modelling
Stock returns can be seen as random variables
Random variables have a probability distribution
o Discrete random variables (e.g., throwing a dice)
o Continuous random variables (e.g., stock return)
Random variables can be characterized using statistical measures
o Expected value (e.g., expected value of throwing a dice is 3.5; estimate is sample average
o Standard deviation (volatility) – amount of variation or dispersion of a set of values (e.g.,
stock return has standard deviation of 0.1)
Different values of the standard deviation Normal distribution
Basic security pricing theory
Standard finance theory: discount future cash-flows with a discount factor
Example:
o Discounted cash flow method
o Gordon growth model (pricing stocks)
The reason why we use a discount factor is that future payments from a security/firm are
uncertain/risky (otherwise, we use the risk-free rate as a discount factor) > discount rate
components: time-value + risk-correction (see e.g., CAPM)
, Mathematically, we think about future cash-flows as random variables that have a probability
distribution
Example: stock price as sum of all future dividend payments:
Here, dividends are random variables, each dividend has
its own probability distribution
Many simplifications are typically made in finance applications for stocks.
Constant discount rate (e.g., WACC)
Do not specify probability distribution, but take expectations
Examples:
- Constant dividend (growth) in Gordon Growth model
- DCF free cash-flows do not have a probability distribution
Textbooks typically provide (mathematically) correct formulates, e.g., CAPM:
Returns themselves are random variables
However, advanced equity pricing models (e.g., Merton model), option pricing models, and credit
risk models do typically not make these simplifications > specify time-series behavior (probability
distribution) of cash-flows
Example:
- Yield curve > different risk-free rate for different time horizons
- Binominal tree for call option price > approximate probability distribution
- Credit risk literature > distinguish default and non-default state.
How to price any asset?
What is the price of this security?
A simple stochastic model (stock)
Assume an all equity firm with only one stock
Aster one time-period, the equity value will be either 0 with 10% probability or 110 with 90%
probability
The discount rate is 10%
