AFM 371 Winter 2008
Chapter 31 - Financial Distress
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Outline
Background
What Happens in Financial Distress?
Bankruptcy Liquidation and Reorganization
Current Issues in Financial Distress
Two Practice Problems From Chapter 16
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Background
Background
as we will see in Chapter 17, financial distress (and its
associated costs) has a potentially large impact on capital
structure decisions by firms
a firm that defaults on a required payment may be forced to
liquidate its assets
however, more often a defaulting firm will restructure
financial restructuring involves replacing old financial claims
with new ones and takes place with either private workouts or
legal bankruptcy
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What is Financial Distress?
Background
financial distress is a situation where a firm’s operating cash
flows are insufficient to meet its current obligations (and so
the firm must take some kind of 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 shareholders
in most cases, the firm is forced to take actions that it would
not have taken if it had sufficient cash flow
insolvency is a term which generally means an inability to
repay debts
stock-based insolvency occurs when the value of a firm’s assets
is less than what is owed on its debt
flow-based insolvency occurs when the firm’s cash flows are
insufficient to cover contractually required payments
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Stock and Flow-Based Insolvency
Background
Stock-Based Insolvency
Solvent Firm
Insolvent Firm
Debt
Assets
Assets
Debt
Equity
Negative Equity
Flow-Based Insolvency
$
Contractual obligations
Firm cash flow
Insolvency
Time
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What Happens in Financial Distress?
financial distress does not always result in the termination of
the firm (is the firm better alive than dead?)
firms deal with financial distress in a variety of ways
asset restructuring includes actions such as:
selling off assets
cutting back R&D and capital spending
merging with another firm
financial restructuring may involve:
cutting dividends
issuing new securities
negotiating with creditors
exchanging debt for equity
filing for bankruptcy
What Happens in Financial Distress?
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The U.S. Experience
No financial
restructuring
49%
Financial
Private
distress
workout
47%
51%
What Happens in Financial Distress?
Financial
Reorganize
restructuring
and emerge
83%
53%
Legal
7%
bankruptcy
Merge with
another firm
10%
Liquidation
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Bankruptcy Liquidation and Reorganization
in a legal bankruptcy, firms effectively have two options:
liquidation or reorganization
liquidation means termination of the firm as a going concern
involves selling the assets of the firm for salvage value
proceeds are distributed to creditors in order of priority
reorganization is the option of keeping the firm as a going
concern
sometimes involves issuing new securities to replace old ones
liquidation usually involves:
a petition is filed in court (either voluntarily by the firm or the
creditors can file an involuntary petition)
a trustee-in-bankruptcy is elected by the creditors to take over
the assets of the firm and try to liquidate them
after the assets are sold, money is distributed to the creditors
(after administrative expenses are paid)
any remaining money goes to the shareholders
Bankruptcy Liquidation and Reorganization
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Priority of Claims in Liquidation
1
2
3
4
5
6
7
8
9
Administrative expenses associated with liquidation
Other expenses arising after the filing of an involuntary
bankruptcy petition but prior to the appointment of a trustee
Wages, salaries, and commissions
Municipal tax claims
Rent
Claims from employee injuries not covered by workers’
compensation
Unsecured creditors
Preferred shareholders
Common shareholders
note that (i) federal income tax must be paid before any of
the above; (ii) secured creditors receive proceeds from sale of
the securing assets (if the amount is insufficient, they join this
list as unsecured creditors); and (iii) courts have considerable
flexibility to deviate from this list
Bankruptcy Liquidation and Reorganization
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Liquidation Example
consider the example on pp. 887-888 in the text
the liquidation value is assumed to be $2.7 million
bonds worth $1.5 million are secured by a mortgage on a
building, which is sold for $1 million
$200,000 is used to cover administrative costs
a total of $2.5 million is available to pay creditors
the unpaid debt is $4 million
following the priority list, the trustee proposes the following
distribution
Type of Claim
Mortgage bonds
Subordinated debentures
Common stock
Total
Bankruptcy Liquidation and Reorganization
Prior Claim
$1,500,000
$2,500,000
$10,000,000
$14,000,000
Cash Received
Under Liquidation
$1,500,000
$1,000,000
$0
$2,500,000
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Bankruptcy Reorganization: A Typical Sequence
1
A voluntary petition can be filed in court by the firm or an
involuntary petition can be filed by the creditors
2
A federal judge either approves or denies the petition
3
In most cases, the debtor continues to run the business
4
The firm is required to submit a reorganization plan
5
Creditors and shareholders are divided into classes
6
After acceptance by creditors, the plan is confirmed by the
court
7
Payments in cash, property, and securities are made to the
creditors and shareholders
note that (i) a class of creditors accepts the plan if a majority
of the class agrees; (ii) secured creditors vote before
unsecured creditors; and (iii) courts have the power to force
uncooperative creditors to accept proposals
Bankruptcy Liquidation and Reorganization
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Reorganization Example
consider the example on pp. 889-890 in the text
assume that the going concern value is $3 million and that the
balance sheet is:
Assets
Liabilities
Mortgage bonds
Subordinated debentures
Shareholders’ equity
$3,000,000
$1,500,000
$2,500,000
-$1,000,000
the firm has proposed a re-organization plan:
Old Security
Mortgage bonds
Subordinated debentures
Old Claim
$1,500,000
$2,500,000
New Claim
$1,500,000
$1,000,000
the proposed distribution of securities is:
Old Security
Mortgage bonds
Subordinated debentures
Bankruptcy Liquidation and Reorganization
New Claim
$1,000,000 in 9% subordinated debentures
$500,000 in 11% subordinated debentures
$1,000,000 in 8% preferred stock
$500,000 in common stock
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Current Issues in Financial Distress
liquidation or reorganization are two formal bankruptcy
procedures
an alternative is a private workout, which is a reorganization
involving direct negotiations between creditors and debtors
in a private workout, usually senior debt is replaced by junior
debt and debt is replaced with equity
when they work, private workouts are better than a formal
bankruptcy (direct costs are only about 10% of a bankruptcy)
a firm with a more complicated capital structure will have
more trouble arranging a private workout
bankruptcy is usually better for equity investors because they
can typically hold out for a better deal (courts violate strict
priority)
a prepackaged bankruptcy is a combination of a private
workout and a formal bankruptcy
the firm and most creditors agree to a private reorganization
the firm then files a formal bankruptcy
idea is to use the courts to force holdouts to agree to a
reorganization
Current Issues in Financial Distress
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Two Practice Problems From Chapter 16
1
Companies A and B differ only in their capital structure. A is financed by
30% debt and 70% equity; B is financed by 10% debt and 90% equity.
The debt of both companies is risk free. Assume that there are no taxes.
(a) Mr. X owns 1% of the common stock of A. What other
investment package would produce identical cash flows for
him?
(b) Ms. Y owns 2% of the common stock of B. What other
investment package would produce identical cash flows for her?
(c) Show that neither Mr. X nor Ms. Y would invest in the
common stock of B, if the total value of company A were less
than that of B.
2
U and L are two firms which are identical in all relevant aspects except
that U is unlevered whereas L has $30 million of perpetual 9% debt.
Assume that the EBIT and corporate tax rate for the firms are $8 million
(perpetual) and 40% respectively, and the cost of capital for U is 12%.
(a) What value would MM place on each of these firms? What is
the expected return on L’s equity?
(b) Suppose that the market is not in equilibrium, so that
VU = $38 million and VL = $44 million, instead of the MM
values. Consider an investor who owns 3% of the shares of U.
What dollar return will this investor receive? Describe in detail
an alternative investment strategy involving ownership of 3%
of the shares of L which produces the same dollar return at
lower cost. The existence of this alternative strategy represents
an arbitrage opportunity. As an investor, how could you exploit
this opportunity?
Two Practice Problems From Chapter 16
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