Bankruptcy and Financial Distress
Professor XXXXX
Course Name / Number
Types of Business Failure
Economic
failure
Return earned by the company is lower than its cost
of capital.
Technical
insolvency
Firm is unable to pay its liabilities as they come due.
Company assets are still greater than its liabilities,
but company is confronted with a liquidity crisis.
Insolvency
bankruptc
y
Firm's liabilities exceed the market value of its
assets.
Courts treat technical insolvency and bankruptcy in the same way.
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Major Causes of Business Failure
Financial distress: the primary cause of business failure
– Over-expansion, poor financial actions, ineffective sales
force, and high production costs
Economic activity, especially economic downturns
– Sales may decrease, leaving the firm with high fixed costs
and insufficient revenues to cover them.
– Rapid rises in interest rates prior to a recession can further
cause cash flow problems.
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Corporate maturity: failure to promote R&D or mergers
Largest Bankruptcies in U.S.
History as of December 2, 2001
Company
Enron Corp.
Texaco, Inc.
Financial Corp. of America
Pacific Gas and Electric Co.
MCorp
First Executive Corp.
Gibraltar Financial Corp.
FINOVA Group, Inc.
HomeFed Corp.
Southeast Banking
Corporation
Reliance Group Holdings,
Inc.
Imperial Corp. of America
Federal-Mogul Corp.
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Bankruptcy Date
December 2, 2001
April 12, 1987
September 9, 1988
April 6, 2001
March 31, 1989
May 13, 1991
February 8, 1990
March 7, 2001
October 22, 1992
September 20, 1991
Total Assets,
Prebankruptcy
$63,392,000,000
35,892,000,000
33,864,000,000
21,470,000,000
20,228,000,000
15,193,000,000
15,011,000,000
14,050,000,000
13,885,000,000
13,390,000,000
June 12, 2001
12,598,000,000
February 28, 1990
October 1, 2001
12,263,000,000
10,150,000,000
Source: http://www.bankuptcydata.com (January 3, 2002)
Voluntary Reorganization
Firm may arrange with its creditors a voluntary settlement:
Extension
Composition
Creditor
control
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Firm’s creditors receive payment in full,
although not immediately.
Pro rata cash settlement of creditor claims
Committee of creditors decides that
operating management be replaced.
Voluntary Liquidation
Credit committee could recommend liquidation of
the firm:
Liquidation: privately or through the legal procedures
provided by bankruptcy law
Objective
Recover as much per dollar owed as possible
Alternative to liquidation - the firm is acquired
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Bankruptcy Law in U.S.
Bankruptcy Reform Act of 1978: contains eight oddnumbered (1 through 15) chapters and chapter 12.
Chapter 7 contains procedures to be followed when
liquidating a failed firm.
Chapter 11 outlines the procedures for reorganizing a firm:
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– Collective legal procedure is begun by which all claims are
resolved.
– Individual creditors are prevented from beginning lawsuits
against the debtor.
– Eliminates the benefit of being the first to sue because all
claims against the firm are settled simultaneously.
Reorganization
Allow businesses in temporary financial distress to
continue operating:
Filing
Appointment
Five steps
Approval
Acceptance of plan
Payment of expenses
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Disadvantage: managers can file for chapter 11 and choose the
bankruptcy procedure that is best for themselves.
Filing
Reorganization petition must be filed in a federal
bankruptcy court by the firm or an outside party.,
Outside party can file for reorganization if:
firm has past-due debts of $5,000 or more,
three or more creditors with aggregate unpaid claims of
$5,000 or more, or
the firm is insolvent.
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Appointment
The filing firm becomes the debtor in possession (DIP) of
the assets:
Creditor committee appointed to represent the interest of
creditors.
DIP is responsible for the valuation of the firm.
– If DIP evaluates the value as a going concern of
the firm lower than liquidation value, recommend
liquidation.
– Otherwise, DIP recommends reorganization.
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Reorganization Plan
DIP submits a reorganization plan to the court:
Key part of reorganization plan
Recapitalization
Debt is exchanged for equity or its maturity is
extended.
Claims on the new securities issued are distributed
based on the seniority of the existing claims.
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Acceptance of the Reorganization
Plan
Court approved plan is submitted for approval to
the firm’s creditors and shareholders.
Under unanimous consent procedure (UCP), creditors
and equity classes must agree with the reorganization plan.
When a reorganization plan fails to meet approval by all
classes under the UCP, use cramdown procedure.
The bankruptcy court can approve the plan without the consent of the
other classes in cramdown. What is the procedure?
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Acceptance of the Reorganization
Plan
– One class of creditors has to vote for reorganization
plan in this case.
– Secured creditors retain their prebankruptcy liens
on assets.
What if no reorganization plan is adopted under either the UCP or
cramdown?
– Managers sometimes voluntarily sell the firm as a
going concern.
– The proceeds of the sale are paid to creditors.
– Creditors could petition for the shift of bankruptcy
filing to Chapter 7 liquidation.
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Payment of Expenses and Capital
Structure Restructuring
• After the reorganization plan has been approved or disapproved
– A statement of expenses is filed; if approved, the debtor must
pay the expenses within a reasonable period
An example....
Current capital
structure for
Campbell
Technologies
Debentures (unsecured debt)
Subordinated debentures
Common stock (100,000 shares)
Total
$22,000,000
$28,000,000
$20,000,000
$70,000,000
Debt/Equity of the company is 2.5 ($50 million/$20 million)
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Campbell Technologies is worth $45 million as a going
concern
Capital Structure Restructuring
• The company could be reorganized as follows
Debentures (unsecured debt)
Subordinated debentures
Common stock (200,000 shares)
Total
$11,000,000
$14,000,000
$20,000,000
$45,000,000
Debt holders receive 100,000 shares in exchange for cutting
their debt claims in half
Debt/Equity ratio is reduced to 1.25 ($25 million/$20
million)
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The financial condition of the company is improved by reducing the
debt!
Liquidation in Bankruptcy
Three
important
aspects
Procedures
Priority of claims
Final accounting
Chapter 7 of Code addresses the order of priority of claims:
1.
The expenses of administering the bankruptcy
2. Any unpaid interim expenses incurred in the ordinary course of business
between filing the bankruptcy petition and the entry of an Order of
Relief in an involuntary proceeding
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3. Wages of not more than $2,000 per worker that have been earned by
workers in the 90-day period immediately preceding the bankruptcy
Liquidation in Bankruptcy
– 4. Unpaid employee benefit plan contributions
– 5. Unsecured customer deposits, not to exceed $900,
resulting from purchasing or leasing a good or service
from the failed firm
– 6. Taxes owed by the bankrupt firm
– 7. Claims of secured creditors, who receive the
proceeds from the sale of collateral held, regardless of
the proceeding priorities
– 8. Claims of unsecured creditors
– 9. Preferred stockholders, who receive an amount up
to the par value of their preferred stock
– 10. Common stockholders, who receive any remaining
funds, which are distributed on an equal per share
basis
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Example: Liquidation of Oxford
Company
Oxford Company Balance Sheet
Assets
Cash
$3,000,000
Accounts payable
$5,000,000
Accounts receivable
10,800,000
Notes payable - bank
23,000,000
Inventories
45,000,000
Accrued wages
2,800,000
Current assets
$58,800,000
Unpaid employee benefits
3,100,000
Net plant
$27,200,000
Unsecured customer deposits
4,000,000
Net equipment
20,000,000
Net fixed assets
$47,200,000
Total
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Liabilities and Stockholders’ Equity
Taxes payable
Total current liabilities
$106,000,000 First mortgage
10,000,000
$47,900,000
$12,000,000
Balance Sheet of Oxford
Company
Oxford Company Balance Sheet
Assets
Liabilities and Stockholders’ Equity
Second mortgage
$8,000,000
Subordinated debentures
10,000,000
Total long-term debt
$30,000,000
Preferred stock (100,000
shares)
$7,000,000
Common stock (1 million
shares)
$14,000,000
Paid-in capital in excess of par
$3,000,000
Retained earnings
$4,100,000
Total common stockholders’
equity
Total
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$28,100,000
$106,000,000
Distribution of Liquidation
Proceeds
•
Oxford Company is liquidating its assets under Chapter 7:
– The trustees obtained $25 million for the firm’s current assets and $22
million for the firm’s fixed assets.
– Oxford has extra liability of $1,000,000 in expenses for administering the
bankruptcy proceedings.
Proceeds from Liquidation
Expenses of administering bankruptcy and paying bills
$1,000,000
Wages owed workers
2,800,000
Unpaid employee benefits
3,100,000
Unsecured customer deposits
4,000,000
Taxes owed government
Funds available for creditors
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$47,000,000
10,000,000
$26,100,000
First mortgage, paid from $22 mil proceeds of fixed asset
sales
12,000,000
Second mortgage, partially paid from the remaining assets
4,000,000
Funds available for unsecured creditors
10,100,000
Predicting Bankruptcy
Altman’s Z score: quantitative model that uses a blend of
traditional financial ratios and multiple discriminant analysis:
About 90% accurate in forecasting bankruptcy one year in the future
About 80% accurate in forecasting bankruptcy two years in the future
Z = 1.2 x X1 + 1.4 x X2 + 3.3 x X3 + 0.6 x X4 + 1.0 x X5
Where
X1 = working capital / total assets
X2 = retained earnings / total assets
X3 = earnings before interest and taxes / total assets
X4 = market value of equity / book value of debt
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X5 = sales / total assets
Poff Industries Balance Sheet
Poff Industries Balance Sheet
Assets
Cash
Liabilities and Stockholders’ Equity
$800,000
A/R
12,000,000
Inventories
25,000,000
Current assets
$37,800,000
Accounts payable
Notes payable - bank
Total current liabilities
Mortgage
$12,900,000
$10,000,000
$9,000,000
Net plant
10,000,000
Net equipment
14,000,000
Preferred stock (100,000 shares)
$5,000,000
Fixed assets
$33,000,000
Common stock (1 million shares)
11,000,000
$70,800,000
Paid-in capital in excess of par
10,000,000
Total long-term debt
Retained earnings
Total stockholders’ equity
Total
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4,900,000
Land
Total
Debentures
$8,000,000
16,000,000
$26,000,000
5,900,000
$31,900,000
$70,800,000
Income Statement of Poff
Industries
Poff Industries Income Statement
Sales
Cost of goods sold
38,000,000
Selling and administrative
$12,000,000
Earnings before interest and taxes
$12,000,000
Interest
Earnings before taxes
Taxes (40%)
Net income
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$62,000,000
2,000,000
$10,000,000
6,000,000
$4,000,000
Z score for Poff Industries
• Company’s stock price currently is $39 per share:
Z = 1.2 x (0.35) + 1.4 x (0.083) + 3.3 x (0.17) + 0.6
x (1.5) + 1.0 x (0.88) = 2.88.
• Using Z score, businesses are classified in:
– Companies with high probability of failure, Z is less
than 1.8.
– Companies with unsure probability of failure, Z is
between 1.81 and 2.99.
– Companies with low probability of failure, Z is higher
than 3.
• Poff Industries has Z score of 2.88
– It is uncertain whether Poff Industries will fail or not
based on the Z score.
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Bankruptcy and Financial Distress
A firm can fail if is technically insolvent or insolvent.
Mismanagement is the primary cause of business
failure.
Companies in financial distress can reorganize or
liquidate.
Bankruptcy Reform Act of 1978 specifies in Chapters
7 and 11, respectively, how firms are
liquidated/reorganized.