31-0
Chapter Thirty One
Financial Distress
Corporate Finance
Ross  Westerfield  Jaffe
31
Sixth Edition
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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31-1
Executive Summary
• This chapter discusses financial distress, private
workouts, and bankruptcy.
• A firm that defaults on a required payment may be
forced to liquidate its assets. More often, a
defaulting firm will reorganize.
• Financial restructuring involves replacing old
financial claims with new ones and takes place with
private workouts or legal bankruptcy.
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Chapter Outline
31.1 What is Financial Distress?
31.2 What Happens in Financial Distress?
31.3 Bankruptcy Liquidation and Reorganization
31.4 Current Issues in Financial Distress
31.5 The Decision to Seek Court Protection: The Case
of Olympia and York
31.6 Summary and Conclusions
Appendix 31-A: Predicting Corporate Bankruptcy: The
Z-score model
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31.1 What is Financial Distress?
• 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.
• Usually the firm is forced to take actions that it
would not have taken if it had sufficient cash flow.
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Insolvency
• Stock-base insolvency; the value of the firm’s assets is less
than the value of the debt.
Solvent firm
Insolvent firm
Debt
Equity
Debt
Assets
Assets
Debt
Equity
Note the negative equity
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Insolvency
• Flow-base insolvency occurs when the firms cash flows are
insufficient to cover contractually required payments.
$
Cash flow
shortfall
Contractual
obligations
Firm cash flow
Insolvency
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time
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The Largest U.S. Bankruptcies
Firm
Liabilities ($m)
Bankruptcy Date
Texaco
$21,603
1987
Executive Life Insurance
14,577
1991
Mutual Benefit Life
13,500
1991
Campeau
9,947
1990
First Capital Holdings
9,291
1991
Baldwin United
9,000
1983
Continental Airlines (II)
6,200
1990
Lomas Financial
6,127
1989
Macy’s
5,300
1992
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31.2 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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What Happens in Financial Distress
No financial
restructuring
Private
workout
Financial
distress
Financial
restructuring
Financial
distress
Legal bankruptcy
Liquidation
Financial
distress
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Reorganize
and emerge
Reorganize
and emerge
Merge with
another firm
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Responses to Financial Distress
• Think of the two sides of the balance sheet.
• Asset Restructuring:
– Selling major assets.
– Merging with another firm.
– Reducing capital spending and R&D spending.
• Financial Restructuring:
–
–
–
–
Issuing new securities.
Negotiating with banks and other creditors.
Exchanging debt for equity.
Filing for bankruptcy.
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31.3 Bankruptcy 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.
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Bankruptcy Liquidation
Straight liquidation usually involves:
1. A petition is filed in a federal court. The debtor firm
could file a voluntary petition or the creditors could file
an involuntary petition against the firm.
2. A trustee-in-bankruptcy is elected by the creditors to
take over the assets of the debtor firm. The trustee will
attempt to liquidate the firm’s assets.
3. After the assets are sold, after payment of the costs of
administration, money is distributed to the creditors.
4. If any money is left over, the shareholders get it.
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Bankruptcy Liquidation: Priority of Claims
The distribution of the proceeds of liquidation occurs according
to the following priority:
1. Administration expenses associated with liquidation.
2. Other expenses arising after the filing of an involuntary
bankruptcy petition.
3. Wages, salaries and commissions.
4. Municipal tax claims.
5. Rent.
6. Claims resulting from employee injuries.
7. Unsecured creditors.
8. Preferred shareholders.
9. Common shareholders.
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Example
• Suppose the B.O. Drug Co. decides to liquidate.
• Assume that the liquidation value is $2.7 million.
Bonds worth $1.5 million are secured by a mortgage
on the corporate headquarters building, which is
sold for $1 million. $200,000 is used to cover
administrative costs and other claims—after paying
this, $2.5 million is available to pay creditors. The
only problem is that the unpaid debt is $4 million.
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Example (continued)
Following our list of priorities, all creditors are paid before
shareholders, and the mortgage bondholders are first in line.
The trustee proposes the following distribution:
Type of Claim
Prior Claim
Cash Received
Under Liquidation
Mortgage Bonds
$1,500,000
$1,500,000
Subordinated
Debentures
$2,500,000
$1,000,000
Common Stock
Total
$10,000,000
$14,000,000
$
0
$2,500,000
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Bankruptcy Reorganization:
A typical sequence:
1. A voluntary petition can be filed by the corporation or an
involuntary petition can be filed by 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 the creditors, the plan is confirmed
by the court.
7. Payments in cash, property, and securities are made to
creditors and shareholders.
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Reorganization Example
• Suppose the B.O. Drug Co. decides to reorganize
under the Bankruptcy and Insolvency Act.
• Assume that the “going concern” value is $3 million
and its balance sheet is shown.
Assets
$3,000,000
Liabilities:
Equity
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Mortgage bonds
$1,500,000
Subordinated
debentures
$2,500,000
-$1,000,000
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Reorganization Example
The firm has proposed the following reorganization plan:
Old Security
Old Claim
Mortgage bonds
$1,500,000
$1,500,000
Subordinated
debentures
$2,500,000
$1,000,000
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New Claim Under
Reorganization
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Reorganization Example
And a distribution of new securities under a new claim
with the reorganization plan:
Old Security
New Claim Under Reorganization
Mortgage bonds
$1,000,000 in 9% subordinated
debentures
$500,000 in 11% subordinated
debentures
Subordinated debentures
$1,000,000 in 8% preferred stock
$500,000 in common stock
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31.4 Current Issues in Financial Distress
• Both formal bankruptcy and private workouts
involve exchanging new financial claims for old
financial claims.
• Usually senior debt is replaced with junior debt and
debt is replaced with equity.
• When they work, private workouts are better than a
formal bankruptcy.
• Complex capital structures and lack of information
make private workouts less likely.
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Private Workout or Bankruptcy: Which is
Best?
•
•
•
In Canada, the new Bankruptcy and Insolvency
Act has added increased costs and time
commitments to the formal bankruptcy
proceedings.
Direct negotiations (private workouts) between
creditors and debtors can be expected to increase.
Bankruptcy is better for equity investors than for
creditors because equity investors can usually hold
out for a better deal in bankruptcy.
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Prepackaged Bankruptcy
• Prepackaged Bankruptcy is a combination of a
private workout and legal bankruptcy.
• The firm and most of its creditors agree to private
reorganization outside the formal bankruptcy.
• After the private reorganization is put together
(prepackaged) the firm files a formal bankruptcy.
• The main benefit is that it forces holdouts to accept
a bankruptcy reorganization.
• Offers many of the advantages of a formal
bankruptcy, but is more efficient.
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The Decision to Seek Court Protection:
The Case of Olympia and York
•
•
•
•
Olympia and York (O&Y) was one of the largest
companies in Canada.
On May 14, 1992, O&Y filed for court protection
in Canada under the Companies’ Creditors
Arrangement Act.
The recession of the early 1990s led to a major
decline in real estate prices and an increase in
vacancy rates.
O&Y (a highly leveraged company) could not
service its debt because of a lack of cash flow.
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The Decision to Seek Court Protection: The
Case of Olympia and York (continued)
•
Costs of the O&Y restructuring include:
1. Direct costs of restructuring.
Legal fees
Accounting fees
Costs of financial advisors
$5.75 million
2.65 million
8.50 million
2. Indirect costs of restructuring: management distraction,
loss of customers, and loss of reputation.
3. Costs of a complicated financial structure: Conflicts
between managers, shareholders, and creditors make
reaching a private agreement difficult.
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31.6 Summary and Conclusions
• Financial distress is a situation where a firm’s
operating cash flow is not sufficient to cover
contractual obligations.
• Financial restructuring can be accomplished with a
private workout or formal bankruptcy.
• Corporate bankruptcy involves liquidation or
reorganization.
• A hybrid of a private workout and formal
bankruptcy is prepackaged bankruptcy.
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Appendix 31-A: Predicting Corporate
Bankruptcy: The Z-score model
• Many potential lenders use credit scoring models to
assess the creditworthiness of prospective
borrowers.
• The general idea is to find factors that enable the
lenders to discriminate between good and bad credit
risks.
• Edward Altman has developed a model using
financial statement ratios and multiple discriminant
analyses to predict bankruptcy for publicly traded
manufacturing firms
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Appendix 31-A: Predicting Corporate
Bankruptcy: The Z-score model (continued)
• The resultant model is of the form:
Z = 3.3(EBIT/Total assets) + 1.2(Net working
capital/Total assets) + 1.0(Sales/Total assets) +
0.6(Market value of equity/Book value of debt) +
1.4(Accumulated retained earnings/Total assets)
where Z is an index of bankruptcy.
• Bankruptcy would be predicted if Z  1.81
and nonbankruptcy if Z  2.99.
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Appendix 31-A: Predicting Corporate
Bankruptcy: The Z-score model (continued)
• Altman uses a revised model to make it applicable
for private firms and non-manufacturers.
• The resulting model is:
Z = 6.56(Net working capital/Total assets)
+ 3.26(Accumulated retained earnings/Total assets)
+ 1.05(EBIT/Total assets) + 6.72(Book value of
equity/Total liabilities)
where Z  1.23 indicates a bankruptcy
prediction.
1.23  Z  2.90 indicates a grey area,
and
Z  2.90 indicates no bankruptcy.
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