equityvalue.Thefirstrelatestotheshiftingdebtloadatthese
firms, as the terms of debt get renegotiated and debt
sometimes becomes equity. The second comes from the
optioncharacteristicsexhibitedbyequity,especiallyinfirms
with significant financial leverage and potential for
bankruptcy.
1 M.Kahl, “FinancialDistress as a SelectionMechanism,”
SSRN working paper, 2001.
2 Foranexaminationofthetheorybehindindirectbankruptcy
costs,see T. Opler andS. Titman,“FinancialDistressand
Corporate Performance,” Journal of Finance 49 (1994):
1015–1040. For an estimate on how large these indirect
bankruptcycostsareintherealworld,seeG.AndradeandS.
Kaplan,“HowCostlyIsFinancial(NotEconomic)Distress?
EvidencefromHighlyLeveragedTransactionsThatBecome
Distressed,”JournalofFinance 53 (1998):1443–1493.They
lookathighlyleveredtransactionsthatsubsequentlybecame
distressed and conclude that the magnitudeof these costs
ranges from 10 percent to 23 percent of firm value.
3 Acertaintyequivalentcashflowreplacesanuncertaincash
flowwithanequivalentrisklesscashflow.Thus,anexpected
cashflowof$125millionwillbereplacedbyarisklesscash
flowof$100million.Themoreuncertainthecashflow,the
greater the downward adjustment.
4 For example, you may increase the likelihood of the
earningsbeinglowiftheearningsinpreviousyearswerelow
andthelikelihoodofnegativemarginsinrevenuegrowthis
low.