Tag Archives | financial distress

Other People’s Money

Other People’s Money (OPM)

In finance, other people’s money, or OPM, is a slang term that refers to financial leverage. Other people’s money refers to borrowed capital that is used to increase the potential returns as well as the risks of an investment. OPM can be used by individuals or by corporations.

Using other people’s money is considered a double-edged sword – it cuts both ways. If an investment that is levered with other people’s money turns out to be profitable, then the profits are magnified by the effects of the leverage. However, if the levered investment goes sour, then the investor that utilized other people’s money can incur steeper losses.

Capital structure refers to a company’s mix of debt and equity financing. Many factors must be considered when determining the optimal mix of debt and equity financing. Increasing leverage, or the use of other people’s money, up to a certain degree can benefit a company by increasing its tax shield. On the other hand, more leverage can increase the risk of default and the incurrence of bankruptcy or financial distress costs.

Other People’s Money Example

Here is an example that demonstrates the risk-return trade-off of using financial leverage, or other people’s money. Let’s say an investor has $100 and plans to invest it in a security that either gains 20% or losses 20% over the course of the year.

If the investment gains 20%, then the investor ends the year with $120, or a profit of $20. However, if the investment losses 20%, then the investor ends the year with $80, or a loss of $20. In either case, the gains and losses represent a reasonable amount in comparison to the original invested capital.

Now, let’s examine the same investment, but with the investor using other people’s money as financial leverage. Let’s say the investor borrows $400 and, along with his original $100, invests a total of $500 in the same investment. The investment will end the year either up 20% or down 20%.

If the investment gains 20%, then the investor ends the year with $600, or a profit of $100. This represents a 100% increase in the original invested capital. On the other hand, if the investment losses 20%, then the investor ends the year with $400, or a loss of $100. This represents a loss of 100% of the original invested capital.

As you can see, the use of other people’s money, or financial leverage, dramatically increased both the upside gains and the downside losses of the investment.

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Other People's Money
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Other People's Money

See Also:
Angel Investor
Venture Capital
Line of Credit (Bank Line)
What are the 7 Cs of banking
Working Capital

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Financial Distress Costs

See Also:
Financial Accounting Standards Board
Financial Instruments
Hedging Risk
Financial Ratios
Finance Beta Definition

Financial Distress Costs

In finance, consider a company to be in financial distress when it is having difficulty making payments to creditors. Financial distress may lead to bankruptcy. The more debt a company uses to finance its operations the more it is at risk of experiencing financial distress. There are several costs associated with financial distress, including bankruptcy costs, distressed asset sales, a higher cost of capital, indirect costs, and conflicts of interest.

Bankruptcy Costs

The more debt a company takes on, the more it risks being unable to meet its financial obligations to creditors. A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore, a highly levered firm has a higher risk of bankruptcy.

Bankruptcy costs vary for different types of firms, but they typically include legal fees and, losses incurred from selling assets at distressed fire-sale prices, and the departure of valuable human capital. The way to measure bankruptcy cost is to multiply the probability of bankruptcy by the expected cost of bankruptcy. A company should consider the expected cost of bankruptcy when deciding how much debt to take on.

Indirect Costs of Financial Distress

There are also several indirect costs associated with financial distress. When a company is experiencing financial distress, conservative managers may cut down on research and development, marketing research, and other investments to spare cash. The firm may also incur opportunity costs if trepid managers pass on risky corporate projects.

Also, financial distress can affect a firm’s reputation. A company in financial distress may lose customers, be forced to pay a higher cost of capital, receive less favorable trade credit terms from suppliers, and be vulnerable to tactics from aggressive industry competitors.

Financial Distress and Conflicts of Interest

Financial distress can incur costs associated with the conflicting self-interests of creditors, managers, and owners.

When a company in financial distress is confronted with a risky investment opportunity, creditors would prefer the company not engage in the risky investment – they would rather the company preserve its assets so they will be able to collect what’s owed to them in the event of default or bankruptcy.

Investors, or owners, on the other hand, would prefer the company to go forward with the risky investment. If the company foregoes the investment, owners don’t benefit. If the company does go for the risky investment, owners have at least some upside gain potential.

While managers may be either conservative in the face of a risky opportunity in order to try to preserve their jobs, or they may be more inclined to take the risk if they side with the shareholders or see the opportunity as a chance to increase personal gain.

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financial distress costs

Source:

Higgins, Robert C. “Analysis for Financial Management,” McGraw-Hill Irwin, New York, 2007.

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Equity Multiplier Definition

See Also:
Define Leverage (Finance)
Operating Leverage
Long Term Debt to Total Asset Ratio Analysis
Debt Ratio Analysis

Equity Multiplier Definition

The equity multiplier definition, also referred to as leverage of a company, is the amount of debt and other liabilities a firm has assumed as a percentage of the total assets on average throughout the year.

Equity Multiplier Meaning

Companies most often use the equity multiplier in finance for purposes of testing the financial strength of a company. If the equity multiplier ratio contains a high amount of debt or leverage, then this means the firm may be reaching distress costs. High levels might also mean that the company has an inability to gain further financing to push into new markets. On the other hand, a company that has a lower equity multiplier debt ratio may not be taking advantage of the tax savings given to companies in the U.S. market. It is up to a firm to decide what its ideal ratio should be by determining an amount of debt that fits with the overall strategy of the company.

Equity Multiplier Equation

Use the following equity multiplier ratio formula to calculate the equity multiplier:

Equity Multiplier = Avg. Total Assets/ Avg. Stockholders’ Equity

equity multiplier definition, equity multiplier equation

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Bankruptcy Information

See Also:

Chapter 7 Bankruptcy
Chapter 11 Bankruptcy
Bankruptcy Code
Chapter 13 Bankruptcy
Bankruptcy Costs
Chapter 12 Bankruptcy
Courts – Bankruptcy

Bankruptcy Information

Bankruptcy is the legal condition of being unable to repay debts. It can apply to individuals or organizations. There are two types of bankruptcy: voluntary and involuntary.

Voluntary bankruptcy occurs when the debtor, the party that owes money, files for bankruptcy. Involuntary bankruptcy occurs when the creditor – the party owed money – files a petition for bankruptcy against the debtor. Voluntary bankruptcy is more common than involuntary bankruptcy.

The idea is to settle the debtor’s debts in an orderly manner that forgives the debt and at least partially repays the creditors. When an entity files for bankruptcy, the creditor values the assets. Then they make arrangements to pay off all or some of the entity’s outstanding debt. After successfully completing the bankruptcy proceedings, the debtor is relieved of its prior debt obligations. This allows them to resume operations.

Bankruptcy laws are stated in the chapters of the Bankruptcy Code. These proceedings take place in Bankruptcy Court.

Bankruptcy Pros & Cons

There are advantages and disadvantages of bankruptcy proceedings. First, filing for bankruptcy allows an entity facing financial distress to settle its debts and essentially start over again. Second, bankruptcy regulations allow creditors to collect at least a portion of what is owed to them. Also, bankruptcy regulations are a sort of safety net, encouraging entrepreneurial individuals and businesses to take risks.

On the other hand, bankruptcy proceedings are expensive for the debtor. An entity filing for bankruptcy may incur legal costs, operational inefficiencies, asset write-downs and liquidation losses, and a higher cost of capital. Also, in bankruptcy proceedings, creditors rarely recoup the full amount owed to them.

Although bankruptcy can be great option for a company with no end in sight, we need to start looking at the valuation aspect. Download the Top 10 Destroyers of Value to maximize the value of your company.

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Bankruptcy Courts

Bankruptcy Courts

All bankruptcies are filed in bankruptcy courts when they are located in the United States. Bankruptcy Courts are also subunits of U.S. District Courts. In addition, every U.S. District Court has a bankruptcy court. Applicable federal and state laws then determine bankruptcy proceedings.

The US Courts website states that, “Bankruptcy helps people who can no longer pay their debts get a fresh start by liquidating assets to pay their debts or by creating a repayment plan. Bankruptcy laws also protect financially troubled businesses.”

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bankruptcy courts

See Also :
Chapter 7 Bankruptcy
Bankruptcy Chapter 11
Chapter 12 Bankruptcy
Bankruptcy Chapter 13
Costs of Bankruptcy
Bankruptcy Code
Bankruptcy Information

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Bankruptcy Code

See Also:
Chapter 7 Bankruptcy
Chapter 11 Bankruptcy
Bankruptcy Costs
Bankruptcy Courts
Chapter 12 Bankruptcy
Chapter 13 Bankruptcy
Bankruptcy Information

Bankruptcy Code

U.S. bankruptcy laws are stated in U.S. Code Title 11 also referred to as the Bankruptcy Code. The code consists of several chapters outlining different bankruptcy categories and procedures. Based on the debtor’s circumstances, the financially distressed debtor can file for bankruptcy under the appropriate chapter. Bankruptcies usually fall into one of two categories, either liquidation or reorganization. Furthermore, bankruptcy proceedings take place in Bankruptcy Courts.

Title 11 – Bankruptcy Code

The chapters of U.S. Code Title 11 include the following:

If you want more details regarding US Code Title 11, then go to: uscode.house.gov

Whether you are facing bankruptcy or are trying to sell, it important to get as much value as possible. If you are in that situation, then click here to download the Top 10 Destroyers of Value to maximize the value of your company as you reorganize or exit.

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Bankruptcy Chapter 7

See Also:
Bankruptcy Information
Chapter 12 Bankruptcy
Bankruptcy Code
Chapter 13 Bankruptcy
Bankruptcy Costs
Bankruptcy Courts
Chapter 11 Bankruptcy

Bankruptcy Chapter 7

Bankruptcy Chapter 7 is a type of bankruptcy proceeding outlined in the Bankruptcy Code. More specifically, Chapter 7 is a liquidation procedure.

When a financially distressed entity files for Chapter 7 bankruptcy, the entity ceases operations and a court-appointed trustee sells the entity’s assets. Use the proceeds from the sale to repay creditors. Then, repay creditors in order of seniority.

Chapter 7 bankruptcy is the most common type of bankruptcy. Furthermore, Chapter 7 bankruptcy is often filed for by individuals.

If you’re in a Chapter 7 bankruptcy, then it’s time to look at how you could have prevented it and how you can avoid it again. Click here download the Top 10 Destroyers of Value.

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