Chapter 30
FINANCIAL DISTRESS
SLIDES
CHAPTER ORGANIZATION
30.1 What Is Financial Distress?
30.2 What Happens in Financial Distress?
30.3 Bankruptcy Liquidation and Reorganization
Bankruptcy Liquidation
Bankruptcy Reorganization
30.4 Private Workout or Bankruptcy: Which Is Best?
The Marginal Firm
Holdouts
Complexity
Lack of Information
30.5 Prepackaged Bankruptcy
30.1 Key Concepts and Skills
30.2 Chapter Outline
30.3 What Is Financial Distress?
30.4 Insolvency
30.5 Insolvency
30.6 Largest U.S. Bankruptcies
30.7 What Happens in Financial Distress?
30.8 What Happens in Financial Distress?
30.9 Responses to Financial Distress
30.10 Bankruptcy Liquidation and Reorganization
30.11 Bankruptcy Liquidation
30.12 Bankruptcy Liquidation: Priority of Claims
30.13 Absolute Priority Rule in Practice
30.14 Reasons for Absolute Priority Rule Violations
30.15 Bankruptcy Reorganization: Chapter 11
30.16 Private Workout or Bankruptcy: Whish Is Best?
30.17 Private Workout or Bankruptcy: Whish Is Best?
30.18 Prepackaged Bankruptcy
30.19 The Z-Score Model: Public, Manufacturers
30.20 The Z-Score Model, Private, Non-Manufacturers
30.21 Quick Quiz
30.6 Predicting Corporate Bankruptcy: The Z-Score Model
ANNOTATED CHAPTER OUTLINE
Slide 30.0 Chapter 30 Title Slide
Slide 30.1 Key Concepts and Skills
Slide 30.2 Chapter Outline
30.1. What Is Financial Distress?
Slide 30.3 What Is Financial Distress?
The text defines financial distress as: “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.”
The most important point is that the firm is forced to take actions
that it would not otherwise choose.
Slide 30.4 –
Slide 30.5 Insolvency
Stock-based insolvency occurs when the value of assets is less than
the value of promised payments to debt.
Flow-based insolvency occurs when operating cash flows are
insufficient to cover contractually required payments.
Lecture Tip: Flow-based insolvency typically results in more
immediate actions, and often leads to bankruptcy. Stock-based
insolvency is commonly regarded as a signal of financial distress.
For example, during the S&L crisis many U.S. banks and S&L’s
were solvent in terms of cash flow but were stock-based insolvent,
i.e., asset values were below liability values. Current accounting
and regulatory practices allow S&L’s to continue operating
despite stock-based insolvency. Stock-based insolvent S&L’s often
are not reorganized by the Resolution Trust Corporation (RTC)
until they face a flow-based crisis. The RTC is the federal agency
charged with reorganizing the assets and liabilities of insolvent
financial institutions.
Slide 30.6 Largest U.S. Bankruptcies
30.2. What Happens in Financial Distress?
Slide 30.7 –
Slide 30.8 What Happens in Financial Distress?
Financial distress can serve as the firm’s “early warning” signal.
Ironically, firms with high financial leverage often face financial
distress earlier and, therefore, have more time to reorganize. Firms
with low leverage may not recognize they are in distress until too
late.
Slide 30.9 Responses to Financial Distress
A firm can respond to financial distress by increasing available
cash flows (asset restructuring) or by reducing liabilities (financial
restructuring). Low leverage firms have very limited options in
financial restructuring, and, due to delay in their response, the asset
values have often deteriorated. For these reasons, firms with low
financial leverage are more likely to liquidate than firms with high
leverage.
Asset Restructuring
1. Selling major assets
Lecture Tip: When Chrysler Corporation was in distress in
1980, it sold its ‘Crown Jewel’ – its highly profitable
division that produced tanks for the U.S. military.
2. Merging with another firm
3. Reducing capital spending and R&D spending
Lecture Tip: Reduced capital spending makes sense if the
foregone projects have negative NPV, perhaps due to a rise
in the cost of capital in the presence of bankruptcy risk.
However, if reduced investment is in response to “Selfish
strategy #2: Incentive to underinvest” from an earlier
chapter, then the firm may be foregoing positive-NPV
projects. In this case, it is not following an optimal
investment strategy.
Financial Restructuring
1. Issuing new securities
2. Negotiating with banks and other creditors
3. Exchanging equity for debt
4. Filing for bankruptcy
30.3. Bankruptcy Liquidation and Reorganization
Slide 30.10 Bankruptcy Liquidation and Reorganization
The Federal Bankruptcy Reform Act of 1978 (as amended by the
Bankruptcy Abuse Prevention and Consumer Protection Act of
2005) provides for two forms of formal bankruptcy: (1) a
bankruptcy liquidation under Chapter 7 of the code and (2) a
bankruptcy reorganization under Chapter 11. Creditors will prefer
Chapter 7 when the liquidation value of the firm is larger than the
value of the firm as a going concern.
.A Bankruptcy Liquidation
Slide 30.11 Bankruptcy Liquidation
Chapter 7 Bankruptcy Liquidation
An involuntary bankruptcy liquidation petition may be filed by
creditors if both of the following conditions are met:
1. The corporation is not paying debts as they come due.
2. If there are more than 12 creditors, at least three with
claims totaling $500 or more must join in the filing. If there are
fewer than 12 creditors, then only one with a claim of $500 is
required to file.
Slide 30.12 Bankruptcy Liquidation: Priority of Claims
Slide 30.13 Absolute Priority Rule in Practice
Slide 30.14 Reasons for Absolute Priority Rule Violations
The absolute priority rule (APR) determines priority of claim in
bankruptcy liquidation and reorganization. The rule states that
senior claims must be fully satisfied before junior claims are
serviced. Exceptions to the APR are possible such as a mortgage
secured by real estate property.
.B Bankruptcy Reorganization
Slide 30.15 Bankruptcy Reorganization: Chapter 11
Chapter 11 Bankruptcy Reorganization
Chapter 11 petitions can be filed by the corporation or by its
creditors. In a Chapter 11 reorganization, the bankruptcy judge has
responsibility for major business decisions, although management
input and cooperation is essential to a smooth reorganization.
30.4. Private Workout or Bankruptcy: Which Is Best?
Slide 30.16 –
Slide 30.17 Private Workout or Bankruptcy: Which Is Best?
In order to avoid the costs and delays of formal bankruptcy, firms
can try to negotiate a private workout with creditors. If creditors
cooperate in a private workout and forego a part of their original
claim, they are betting that their ultimate payoff will be higher than
if the firm were to be dragged through the bankruptcy courts.
Lecture Tip: Gilson [1989] estimates that only 30% of senior
managers (CEO, chairman, and president) survive the four- year
period starting two years prior to a Chapter 11 bankruptcy filing.
The survival rate of senior management in private workouts was
only slightly higher at 40%.
Advantages of Formal Bankruptcy versus Private Workout
1. Formal bankruptcy allows firms to issue new debt (“debtor
in possession” or “DIP” debt) that is senior to all previously issued
debt. This new senior debt can provide enough cash for the firm to
continue to conduct its business.
2. Interest on pre-bankruptcy unsecured debt stops accruing
after formal bankruptcy is recognized.
3. An automatic stay provision protects the firm from its
creditors during bankruptcy proceedings.
4. There are tax advantages to formal bankruptcy relative to
private workouts.
5. While a private workout requires acceptance of the plan by
all creditors, formal bankruptcy requires acceptance of the plan by
one-half of creditors owning 2/3 of outstanding claims.
Disadvantages of Formal Bankruptcy versus Private Workout
1. Legal and professional fees have top priority according to
the absolute priority rule. Because legal fees accrue on an hourly
basis, lawyers and investment bankers have little reason to work
toward a rapid reorganization of the firm.
2. In a bankruptcy reorganization through Chapter 11, judges
are required to approve all major business decisions. All
stakeholders can be adversely affected if judges make financing
and investment decisions that are not based on maximizing firm
value. Lost investment opportunities represent one form of
opportunity costs in bankruptcy proceedings.
3. Similarly, if managers’ attention is diverted by the
bankruptcy proceedings, they may not pursue all positive-NPV
investment opportunities.
4. Stockholders may be able to “hold out” for a better deal in
Chapter 11 bankruptcy than in a private workout because interest
on pre-bankruptcy debt has stopped accruing and the availability of
“debtor in possession” debt.
.A The Marginal Firm
Lecture Tip: There are two potentially important tax advantages
to Chapter 11 bankruptcy over a private workout. First, in a
private workout, tax loss carry forwards are forfeit if the
ownership claim of original shareholders is diluted to less than
50% of the firm. Second, if debt is exchanged for less than its
original face value, the reduction of face value is taxed as if it
were income, despite the fact that it is in recognition of a real
economic loss. If the firm goes through Chapter 11 bankruptcy, the
tax liability related to “cancellation of indebtedness” is forgiven.
.B Holdouts
Lecture Tip: Bondholders also can have an incentive to resist
private workouts and “hold out” for a larger payoff. The problem
of bondholder holdouts became the focal point in January 1990
during bankruptcy rulings on LTV Corporation. Prior to filing for
bankruptcy in 1986, LTV arranged a private workout in which
some bondholders voluntarily received bonds with market values
well below the face value of their original bonds. When LTV finally
went through Chapter 11, the court ruled that bondholders
participating in the swap had given up their claim to their original
face value. Bondholders not participating in the swap retained
their original claim on the firm. Consequently, bondholders that
“held out” were rewarded with a larger payoff during bankruptcy
proceedings. A prepackaged bankruptcy could have forced all
bondholders to participate on a pro rata basis and preserved the
relative claims of all participants.
.C Complexity
A firm with a complicated capital structure will have difficulty
constructing a private workout.
.D Lack of Information
A greater degree of information asymmetry (particularly between managers,
bondholders, and equity holders) will make it more difficult to
complete a private workout.
30.5. Prepackaged Bankruptcy
Slide 30.18 Prepackaged Bankruptcy
By negotiating with creditors prior to a formal bankruptcy filing,
corporations can combine the best characteristics of private
workouts and formal bankruptcy.
Lecture Tip: McConnell and Servaes [1991] view prepackaged
bankruptcies as an administrative extension of an informal
reorganization, with the following advantages:
1. Because only one-half of creditors holding at least
two-thirds of the firm’s liabilities are needed for approval of a
bankruptcy plan, holdouts can be reduced.
2. In addition to reducing holdout disputes, prepackaged
bankruptcies can capture all of the advantages of formal
bankruptcy (including tax advantages) while minimizing the
disadvantages.
By agreeing to a prepackaged bankruptcy, existing debtholders can
preserve their priority of claim and avoid a possible reduction in
value from the use of new “debtor in possession” (DIP) debt.
30.6. Predicting Corporate Bankruptcy: The Z-Score Model
Slide 30.19 The Z-Score Model: Public, Manufacturers
Credit scoring models provide a quick, objective way to assess the
creditworthiness of prospective borrowers by assessing factors that
have historically been associated with the risk of default.
Altman’s Z score is found using the following equation:
Z = 3.3*(EBIT/Total Assets) + 1.2*(NWC/Total Assets)
+ 1.0*(Sales/Total Assets) + .6*(MV Equity / BV Debt)
+ 1.4*(Accumulated RE / Total Assets)
A Z-score less than 2.675 is indicative of a high probability (95%)
of declaring bankruptcy within the next year. However, 1.81 to
2.99 is really a grey area, with the critical high and low
probabilities of bankruptcy being below 1.81 and above 2.99,
respectively.
Slide 30.20 The Z-Score Model: Private, Non-Manufacturers
The above model requires a firm to have publicly traded equity and
be a manufacturer. A revised model can be used on private firms
and non-manufacturing companies:
Z = 6.56*(NWC/Total Assets) + 3.26*(Accumulated RE / Total
Assets) + 1.05*(EBIT/Total Assets) + 6.72*(BV Equity /
Total Liabilities)
The critical levels for this model are 1.23 and 2.90, respectively.
Slide 30.21 Quick Quiz