Executive Summary

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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 firms 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 firms
  assets is less than the value of the debt.

Debt
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Insolvency

• Flow-base insolvency occurs when the firms cash
  flows are insufficient to cover contractually
  required payments.

Firm cash flow
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The Largest U.S. Bankruptcies
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31.2 What Happens in Financial Distress?

• Financial distress does not usually result in the
  firms 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
Financialdistress
Financialdistress
Reorganize and emerge
Liquidation
Reorganize and emerge
Financialdistress
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 RD 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
• 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.
• 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
  firms assets.
• After the assets are sold, after payment of the
  costs of administration, money is distributed to
  the creditors.
• 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
• Administration expenses associated with
  liquidation.
• Other expenses arising after the filing of an
  involuntary bankruptcy petition.
• Wages, salaries and commissions.
• Municipal tax claims.
• Rent.
• Claims resulting from employee injuries.
• Unsecured creditors.
• Preferred shareholders.
• 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
  claimsafter 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

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Bankruptcy Reorganization

• A typical sequence
• A voluntary petition can be filed by the
  corporation or an involuntary petition can be
  filed by creditors.
• A federal judge either approves or denies the
  petition.
• In most cases the debtor continues to run the
  business.
• The firm is required to submit a reorganization
  plan.
• Creditors and shareholders are divided into
  classes.
• After acceptance by the creditors, the plan is
  confirmed by the court.
• 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.

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Reorganization Example

• The firm has proposed the following
  reorganization plan

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Reorganization Example

• And a distribution of new securities under a new
  claim with the reorganization plan

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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 (OY) was one of the largest
  companies in Canada.
• On May 14, 1992, OY 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.
• OY (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 OY restructuring include
• Direct costs of restructuring.
• Legal fees 5.75 million
• Accounting fees 2.65 million
• Costs of financial advisors 8.50 million
• Indirect costs of restructuring management
  distraction, loss of customers, and loss of
  reputation.
• 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 firms
  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.