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Corporate
Finance FIN 622
VU
Lesson
37
FINANCIAL
DISTRESS AND FOREIGN EXCHANGE
MARKET
The
following topics are covered
in this hand out:
Sources
of financial distress
Effects of
financial distress
Reorganization
We can
divide the sources of financial distress
into three
categories:
a-
Firm level causes of financial
distress
b-
Industry level causes
c-
Macro level factors causing financial
distress
a.
Firm Level Causes
These
factors are specific to a particular
firm and include i) ownership and
governance, b) operating risk
and c)
leverage.
For
example, agency costs
connected with managerial discretion
and debt, depending on the extent
that
they
are not mitigated through contracting
devices can affect a firm's operational
efficiency, leverage,
profitability
and risk. However, if a firm is
observed to be in financial distress,
and even if the cause of
the
distress
can be traced explicitly to
bad decisions by management, it
may be difficult to distinguish
whether
the
decisions that contributed to
distress are due to
management's self-serving behavior or
to
incompetence.
b.
Industry Level Causes
Competition:
Five
forces of industry competition are
useful for identifying
possible industry level causes of
financial
distress.
These forces are 1) entry /
exit barriers, 2) bargaining power of
vendors 3) bargaining power of
buyer 4) threat of
substitute products and 5)
rivalry among competing firms.
A
negative shock to an industry's product
demand or costs especially if it is
sustained over time,
will
eventually force a
shakeout of firms in the industry. The
weakest firm will be forced
into liquidation or
must
consider being acquired by a stronger
firm in the industry.
The
leverage helps boost a firm's
sales growth relative to that of
its industry rivals because the
firm commits
to
aggressive competitions in the product
markets, which leads less
aggressive competitors to yields part
of
their
market share. The firm
may deliberately choose low
leverage so as to be able to pursue
predatory
market
strategies to squeeze a high-levered
rival, perhaps to the point of
bankruptcy.
The
industry shocks contribute to the
frequency of takeover and restructuring
activity. Shocks include
deregulation,
changes in input costs, and
innovations in financing technology that
induce or enable
alterations
in industry structure. The inter-industry
patterns in the rate of takeovers
and restructurings
are
directly
related to the economic shocks
borne by the sample
industries.
Financial
researchers and thinkers have
investigated the effect of a bankruptcy announcement
by one firm
on the
values of other firms in the industry. There
are two conflicting effects.
On one hand, there may
be
contagion effect.
The market may lower the
value of other firms in the industry
because the bankruptcy
announcement
reveals new negative
information about the status of the industry as a
whole. On the other
hand,
the market may raise the
values of other firms in the industry
because on of their rival
has failed.
The
deregulation of an industry can induce financial
distress in many firms within the
industry as the
economic
structure of the industry changes. Over
the last decade, Pakistan
has deregulated the
transportation
industry (airline and rail), communication industry
and several public sector
giant industries
including
Pakistan Steel.
c. Macro-Level
Causes
Recessions
create financial distress by narrowing
the margin between cash flow
and debt service. When
the
flow
constraint is relevant, a principal effect of drop in
current income is the reduction of expenditure
on
illiquid
and long-lied assets. There
are two reasons for
this. First, lower current income
increases the short
run
probability that the flow constraint
will have to be satisfied
through costly means, for
example, the
distress
sales of assets, borrowing at unfavorable
terms, sever reduction in current
living standard, or as the
last
resort, bankruptcy. Secondly, a drop in
current income typically has
ambiguous implications for the
consumers'
estimates of future income
flows and, hence, for the
level of durables holdings consistent
with
maintenance
of solvency in the long run.
Because durables are
illiquid, it is more costly to
correct an over
purchase
than an under purchase. Assuming
that waiting for new
information will tend to
resolve the
ambiguity
created by the initial income
fall even a risk neutral consumer
will be motivated to defer
durables
purchases
until the uncertainty is resolved.
127
Corporate
Finance FIN 622
VU
Monetary
Policy: liquidity reminds us the critical
role of monetary policy on the nation's
overall liquidity.
The
state bank affects the level of aggregate
liquidity primarily through
its open market operations.
These
operations
involve the SBP buying or
selling T-bills and Govt.
securities out of its
considerable inventory,
to affect
its intended policy to ease or
tighten liquidity in the banking
system. When it buys bills,
an
expansionary
maneuver, it adds legal
reserves to the banking industry, which
the nation's banks can use
to
create
new loans on a multiplied
basis. Selling bills has the
opposite or contradictory effect. Short-term
interest
rates fall when the SBP is
pursuing an expansionary policy, and
rise when contradictory policy is
being
pursued.
The
primary duty of central bank is to
protect the purchasing power of rupee,
while also allowing for
a
sustainable
level of real growth in the economy.
The SBP operates under the
assumptions that inflation
is
positively
related to real economic
growth. On one hand, if real
economic growth is weak, the
state bank
can
pursue an expansionary policy
without much concern about
inflation.
On the
other hand, when economy is
overheated, state bank eventually steps
in with contradictory policy to
cool
the economy and thereby reduce
inflation. Of course, a consequence of
contradictory monetary policy
is a
rise in the rates on, and
tighter limits on the availability of
short-term loans.
Effects
of Financial Distress:
Cost
associated with the entire real
world factors that we have
covered so far are
exacerbated when a fir is
operating under
financial distress.
Loss
of Tax Benefit: if a levered
firm fails to make profits
on a chronic basis, it looses the value
of the tax
shield
provided by debt interest
and depreciation. Depending on the firm's
initial leverage and
depreciation
base,
these losses alone can
place the firm at a competitive
and strategic
disadvantage.
Transaction
Costs: the cost of transacting in the
financial markets is much higher fro
firms in financial
distress.
In some cases, the capital
markets may be effectively
closed to a firm that is in
severe distress, in
part
because, given the effort required by an investment
bank that float the firm's
equity or debt
securities,
the required
underwriter spread would be
prohibitively high.
Increase
in Illiquidity: significant losses in the
market value of a firm's equity
can have several
negative
liquidity
effects. First, the firm may
lose some professionals who
play vital role is supporting the
flow of
information
about a stock, which is critical to
liquidity. Secondly, the investors'
interest in trading that
stock
may
reduce resulting in increase in the
bid-ask spread. Third, there
are chances that stock
exchange may de-
list
that stock, but this will
depend on the regulations of stock
exchange.
At this
point, the firm has lost
most of its potential to
raise equity funds; raising debt funds
will be more
difficult
as well. Moreover, this may come at a
time when the firm is most in
need of external funds to
survive.
Capital
Reconstructions:
These
types of schemes can be undertaken
for different purposes. We
can divide them into two
broad
categories;
- Scheme
undertaken where company is in financial
distress
- Scheme
undertaken where company is not in
financial crisis
However,
there may be a situation, which
may have characteristics of
both of the above situations.
A
company
may heading towards financial
distress and decides to go
for reconstruction.
The
firms in financial distress may undertake
restructuring to improve both their
mix of different types
of
capital
and the timing of availability of funds.
The main objectives of reorganization
may be from the
following
factors. It may be a single
factor or combination of
several.
- To
reduce the after tax cost of
borrowing
- To
settle the loans sooner or
later
- To
improve security of
finance
- To
improve financial image of the
company
- To
make company more attractive to the
investors
- To
cleanse balance sheet
Types
of reorganization:
The
following are the types of
reorganizations:
- conversion of
debt to equity or vice
versa
- conversion of
equity from one class to
other
- conversion of
debt from one class to
another
128
Corporate
Finance FIN 622
VU
FOREIGN
EXCHANGE MARKET
Today,
most of the businesses are
not just conducting their trade in
one currency. They have to
trade in
more
than one currency. All the
currencies except the home
currency are known as
foreign currencies. This
is
extremely large market and
most of the transactions are
carried out using the
telecommunication
technology
like telephone, email, fax
etc. The main market
players are central banks,
banks and For-ex
(Foreign
exchange) dealers conducting trade on
behalf of their clients including
business firm,
governments.
The
existence of FX market is of crucial
importance in the development of international trade
that requires
the
use of foreign currency. FX
market is very competitive as there
are several buyers and
sellers,
standardized
procedures and regulations,
commodity is homogeneous and
most of the times
transactions
are
being carried out over the
phone without physical
participation. The prices of
currencies are determined
by
demand and supply.
Exchange
rates: an exchange rate is the
price of one currency in
terms of another. There are two
currencies
involved
a base and variable.
When a FX dealer quotes in
terms of Pak Rs. / US $,
then he is referring the
rate
for the number of US $ to one Pak
rupee.
For
one exchange rate (Pak
Rs. / US $) there are two
types of rates normally quoted.
That is bid and
offer
rate.
Bid rate is lower than the
offered rate.
A
dealer/bank may express
PKR/US$ as 60.5500
60.5900
Bid
price lower price, a
price at which the dealer
will sell the variable
currency.
Offer
price higher price, a price at
which the dealer will buy
the variable currency.
At
60.5500, dealer will sell US
$ in exchange for PKR
At $
60.5900 dealer will buy US $
in exchange for PKR
The
difference between bid and
offer prices is know as
spread and represents the
gross margin of the
FX
dealer.
Spot
Rates:
Foreign
currencies can be traded on either
spot or forward.
Trading
spot means that the
settlement will be now
extended to two working days
after the transaction is
made.
Buying or selling forward
means that settlement will
be made at an agreed future
date. Therefore,
there
will be different rates for
spot and forward for an
identical pair of currencies. Forward
contracts have
settlement
date up to one year with
exception to major currencies where it
can be two years.
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