CORPORATE FINANCIAL DECISION

MAKING (FNCE 20005)

Dr Chander Shekhar
University of Melbourne
Faculty of Business and Economics
Department of Finance

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LECTURE 10
Behavioural Finance - Textbook: Chapter 22 (pg. 703-705)
Corporate Distress - Textbook: Chapter 16

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Outline of Lecture 10
• Behavioural Finance
• What Is Financial Distress?
• What Happens in Financial Distress?
• Bankruptcy Liquidation and Reorganization.
• Predicting Corporate Bankruptcy: The Z-Score
Model.

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Behavioural Finance
• Managers are less than fully rational
• Roll (1986) outlines a hubris‐based theory of acquisitions.
• He suggests that successful acquirers may be optimistic and
overconfident in their own valuation of deal synergies and fail to
properly account for the winner’s curse.
• Malmendier and Tate (2004) develop this argument and use their
options‐based proxy for CEO overconfidence to test it.
• Overconfident CEOs are the ones who do not exercise their options
even when they are “in the money.”
• These CEOs complete more mergers, especially diversifying mergers,
which are typically suggested as being of dubious value.
• Investors are more skeptical about bid announcements when they are
made by overconfident CEOs.
• Hackbarth (2002) found a positive relationship between overconfidence
and level of debt
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Overoptimism
• Overoptimism is usually modeled as an overestimation of an outcome – overestimating

the probability of a good outcome or underestimating the probability of a bad outcome

• Ben‐David, Graham, and Harvey (2010) ask financial executives to estimate the mean

and variance of market return.

• Financial executives exhibit overoptimism: their subjective 80% confidence intervals about the market’s one‐year
return contains the realized return only 33% of the time.

• They also find that both optimism and overconfidence are associated with higher investment.

• Survey evidence confirms that entrepreneurs tend to be overoptimistic about their

future success.

• Overconfidence and overoptimism have obvious costs, but they can also help

shareholders by encouraging risk-averse managers to take good risky or innovative

projects (Campbell et al. 2011).

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What Is Financial Distress?
• Financial distress is a situation where a firm’s operating
cash flows are not sufficient to satisfy current obligations
and the firm is forced to take corrective action.
• Financial distress may lead a firm to default on a contract,
and it may involve financial restructuring between the firm,
its creditors, and its equity investors.

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Insolvency - 1
• Stock-based insolvency: the value of the firm’s assets is
less than the value of the debt.

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Insolvency - 2
• Flow-based insolvency occurs when the firms cash flows
are insufficient to cover contractually required payments.

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Investment distortions when a firm is close to
bankruptcy
Excessive risk-taking (asset substitution)

• Shareholders have unlimited upside potential but bounded losses

• When a firm faces financial distress, shareholders are tempted to gain by
gambling (negative NPV projects) at the expense of debt holders

Debt overhang (underinvestment)

• When a firm is in financial distress, managers may prefer to pay out cash to
shareholders - perhaps in the form of a dividend - than fund projects (even
positive NPV projects) because most of the benefits would go to the firm’s
existing creditors
• New shareholders will not buy equity at existing prices but require a
substantial discount
• Existing shareholders will reject this as their interests are diluted.

These distortions are likely to occur when there is a significant probability of

bankruptcy

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Large U.S. Bankruptcies: 2008 through
the Second Quarter of 2020

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Australian bankruptcy - Rough landing ahead for Virgin
Australia bondholders - Jun 25, 2020

https://www.nasdaq.com/articles/rough-landing-ahead-for-virgin-australia-
bondholders-2020-06-25
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Virgin and Bain Capital - Stage1
[https://www.abc.net.au/news/2020-09-04/bain-capital-new-owner-of-virgin-australia-creditors-vote-yes/12629528]

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Virgin and Bain Capital – Stage 2
[https://money.usnews.com/investing/news/articles/2023-01-15/bain-capital-explores-virgin-australia-ipo]

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Virgin and Bain Capital – Stage 2.1
[https://www.afr.com/street-talk/virgin-australia-cancels-aussie-ipo-meetings-expected-to-reschedule-
20230417-p5d10j]

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What happens in financial distress?
• Financial distress does not usually result in the firm’s
death.
• Firms deal with distress by:
• Selling major assets.
• Merging with another firm.
• Reducing capital spending and research and development.
• Issuing new securities.
• Negotiating with banks and other creditors.
• Exchanging debt for equity.
• Filing for bankruptcy.

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Australia moving towards a US Chapter 11 style
bankruptcy model
Following is based on https://www.claytonutz.com/from-red-to-black-
2021/will-debtor-in-possession-be-the-future-of-insolvency#
• On 1 January 2021, the small business restructure along with a
simplified liquidation process commenced, with the intention of being
cost-effective and more expeditious alternatives to voluntary
administration.
• The small business restructure is a debtor in possession model which
provides eligible small businesses the opportunity to appoint a
restructuring practitioner to develop a restructuring plan with the aim
of reaching an agreement with creditors to secure the company's
survival.
• Directors maintain control and the company continues trading in the
ordinary course of business.

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Australia moving towards a US Chapter 11 style
bankruptcy model
• The company is also provided with breathing space via a moratorium on any
creditor recovery proceedings and enforcement of guarantees, ipso facto
protections and relief from insolvent trading laws.
• The small business restructure is only available to companies with liabilities of
less than $1million and included in this calculation are all related party, secured,
unsecured and contingent debts.
• To be eligible companies must have all tax reporting obligations up to date
(payment is not required) and have paid all employee obligations including
superannuation.

• Readings (optional)

• Australia to overhaul bankruptcy laws to help firms over COVID-19

(https://www.reuters.com/article/us-health-coronavirus-australia-bankrupt-idUSKCN26F00F)

• Will debtor in possession be the future of insolvency?

(https://www.claytonutz.com/from-red-to-black-2021/will-debtor-in-possession-be-the-future-of-
insolvency)

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Liquidation and Reorganization
• Firms that cannot meet their obligations have two choices:
liquidation or reorganization.
• Liquidation means termination of the firm as a going concern.
• It involves selling the assets of the firm for salvage value.
• The proceeds, net of transactions costs, are distributed to creditors
in order of priority.
• Reorganization is the option of keeping the firm a going
concern.
• Reorganization sometimes involves issuing new securities to
replace old ones and selling assets to pay off debt
• Choice between liquidation and reorganization typically
depends on the judgement whether the firm is worth more
‘dead’ or ‘alive’
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Liquidation
• A company may voluntarily file a petition for liquidation or
its creditors may file one for the firm
• A court (or creditor) appointed administrator attempts to
liquidate the assets
• The proceeds of liquidation (minus administration costs)
are distributed to the creditors
• If any proceeds remain after expenses and distribution to
creditors, they are distributed to the shareholders

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Tuesday Morning’s second bankruptcy
[https://www.retaildive.com/news/tuesday-morning-going-out-of-business-store-closures/649038/]

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Absolute priority rule
• Proceeds of liquidation are distributed as per the absolute
priority rule (APR)
• Higher you are on this list, more likely your claim will be paid
• Secured creditors are paid from sale of the security
(typically property) and are outside the priority list
• If proceeds are insufficient to cover secured creditor claims, they
join other unsecured creditors in dividing up the remaining
liquidated value
• If the proceeds are in excess of claims, net proceeds are used to
pay unsecured creditors and others
• APRs are frequently violated – distribution of proceeds in
a bankruptcy are typically subject to much negotiation

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Predicting Corporate Bankruptcy: The Z-Score Model

• Credit scoring models provide a quick, objective way to

evaluate creditworthiness.
 EBIT   NWC 
Altaman's Z − Score = 3.3   + 1.2  +
 Total Assets   Total Assets 
 Sales   MV Equity   Accumulated RE 
1.0   + .6   + 1.4  
 Total Assets   BV Debt   Total Assets 
• EBIT = Earnings before interest and taxes; NWC = Net working capital; RE =
Retained earnings
• Z-Score < 1.81 indicates high probability of bankruptcy.
• Z-Score between 1.81 and 2.99 is a grey area.
• Z-Score > 2.99 indicates a low probability of bankruptcy.

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Predicting Corporate Bankruptcy: The Z-
Score Model - example
US Composite Inc. is requesting that its bank increase its line of credit and has provided the following
information to the bank:
• Total assets $75,000
• EBIT $6900
• NWC $3400
• Book value of equity $19000
• Accumulated RE $16800
• Sales $92000
USC stock price is $21 per share and there are 5000 shares outstanding. What is the Z-score for this
company?

Market value of equity = 5,000($21) = $105,000

We also need the book value of debt. Since we have the value of total assets and the book value of equity, the book
value of debt is the difference between these two, or:

Book value of debt = Total assets – Book value of equity

Book value of debt = $75,000 – 19,000
Book value of debt = $56,000

Z-score = 3.3($6,900/$75,000) + 1.2($3,400/$75,000) + ($92,000/$75,000) +.6($105,000/$56,000)+1.4($16,800/$75,000)

Z-score = 5.214

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D2D (distance to default) model (optional reading)

https://home.kpmg/au/en/ho
me/insights/2022/01/default
-indicator-australian-listed-
companies-volume-10.html

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D2D (distance to default) model (optional reading) – Zombie companies across the ASX – June 2021
https://home.kpmg/au/en/home/insights/2022/01/default-indicator-australian-listed-companies-volume-10.html

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Summary of Lecture

Behavioural Corporate
Finance Distress

Investment Predicting
Overconfidence Optimism Reorganization Liquidation
distortions bankruptcy

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After Today’s Class,
You should be able to answer the following questions:
• What are overconfidence and optimism
• What is financial distress and understand what
investment distortions may occur in financial distress
• What are the basic ideas of related to liquidation and
reorganization
• What is “absolute priority”
• How can Z-Score Model be used to predict bankruptcy

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