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Ebook Corporate finance (8th edition): Part 2

(BQ) Part 2 book "Corporate finance" has contents: Valuation and capital budgeting for the levered firm, cash management, credit management, mergers and acquisitions, financial distress, international corporate finance, warrants and convertibles, derivatives and hedging risk, options and corporate finance,.and other contents. | www.downloadslide.com CHAPTER 16 Capital Structure Limits to the Use of Debt Airlines have traditionally relied heavily on the use of financial leverage. Unfortunately, this practice can have adverse consequences when things don’t work out as planned, as the airline industry has plainly (and painfully) showed. For example, on February 1, 2006, United Airlines emerged from Chapter 11 bankruptcy after spending 38 months in the bankruptcy process. Even though the company reorganized its balance sheet, it still faced problems. During 2005, United posted a loss of $741 million, and its loss in the fourth quarter of the year was its 22nd consecutive quarter with red ink. Of course, other big airlines were still in bankruptcy. Delta Air Lines lost $3.8 billion in 2005, including $1.2 billion in the fourth quarter, and entered bankruptcy in September 2005. Northwest Airlines, also facing huge losses, filed at the same time as Delta. In both cases, it is likely to be some time before the companies emerge from the bankruptcy process. In early 2006, another five smaller airlines were also in bankruptcy. As these situations point out, there is a limit to the financial leverage a company can undertake, and the risk of too much leverage is bankruptcy. In this chapter, we discuss the costs associated with bankruptcies and how companies attempt to avoid this process. 16.1 Costs of Financial Distress Bankruptcy Risk or Bankruptcy Cost? As mentioned throughout the previous chapter, debt provides tax benefits to the firm. However, debt puts pressure on the firm because interest and principal payments are obligations. If these obligations are not met, the firm may risk some sort of financial distress. The ultimate distress is bankruptcy, where ownership of the firm’s assets is legally transferred from the stockholders to the bondholders. These debt obligations are fundamentally different from stock obligations. Although stockholders like and expect dividends, they are not legally entitled