FINANCIAL RESTRUCTURING

VALUE OF THE FIRM

Value of all equity financed firm:
+ PV of tax shields
+ PV of other benefits of leverage
+ PV of benefits of control change
+ PV of benefits from M&As
+ PV of benefits from changes in strategy,
policy, structure, etc.
– PV of costs of financial distress
= Value of the firm

LEVERAGE AND LEVERAGED RECAPS

M&A effects of capital structure decisions
Debt can be source of funding for
acquisitions
Debt can discourage potential acquirers

Leveraged recapitalization (LR) characteristics

Large issue of debt, proceeds used to buy
back shares
Usually increases management ownership
(9% to 24% on average)
 Book leverage (total debt / total
capitalization) increases from 20% to 70%
on average

Market response to LR announcements

Used as takeover defense – both positive and
negative returns
Proactive LRs:
Cumulative abnormal return of about
+30%
Return to bondholders of +5%

Subsequent performance
High rate of financial distress
Debt plays positive disciplinary role
Success affected by: business economic
conditions, achievement of operating
improvements

DUAL-CLASS RECAPITALIZATIONS
Characteristics of DCRs
Creates second class of stock with limited
voting right, but a preferential claim on
cash flows
 Example: Class A – 1 vote, high dividends;
Class B – multiple votes, low dividends
Patterns: officers & directors have 55-65% of
voting rights but only 25% of cash flow
claims
Many DCRs used to consolidate control in the
hands of a founding family or their
descendants

Reasons for DCRs

Management solidifies control to implement
long-run programs
Helpful in complex operations where
managers may have superior understanding
Negative – could result in management
entrenchment
Market response – not adverse
Abnormal return of +6% in preceding 90-
days
Abnormal return of +1% around
announcement
Firms with superior voting rights receive
more in takeover – sell at a premium

Why are DCRs approved by shareholders?

 Wealth transfer of higher dividends is
incentive to accept lower compensation in
takeover
DCRs in growing industries, LBOs in mature
industries (Lehn et al, 1990)
Managers in DCRs usually have large stake
LBOs more likely to be takeover defense
DCRs often accompanied by increase in
external control: increase in outside
directors, little change in dividend policy,
etc. (Moyer et al, 1992)

EXCHANGE OFFERS
Exchange offer characteristics
Right or option to exchange holdings for
different class of firm securities
New securities usually have higher market
value to induce security holders to
exchange
Tax: exchange of securities may result in
recognition of gain/loss

Distressed exchanges
Firms restructure assets and liabilities due to
deteriorating financial condition
Lie et al (2001) – debt-reducing exchange
offers try to avoid Chapter 11 and preserve
value for stockholders
Empirical Evidence
Positive returns
Debt for c. stock +14.0%
Pfd. for c. stock +8.2%
Debt for pfd. stock +2.2%

Characteristics:
Leverage increasing
Imply high future cash flows, undervaluation
Increase management ownership
Positive signaling

Negative returns
C. stock for debt -9.9%
Pfd. stock for debt -7.7%
C. for pfd. stock-2.6%

Characteristics:
Leverage decreasing
Imply low future cash flows, overvaluation
Decrease in mgmt. Ownership
Negative signaling

REORGANIZATION PROCESSES
Financial distress – liquidation value of firm is
less than face value of creditor claims
Out-of-court procedures
Exchange: equity claim for debt priority claim
Extension: maturity of debt can be
postponed
Composition: obligations can be scaled down
Merger into another firm
Bidder return tied to post merger
performance
Financial distress easier to restructure than
poor operating performance
Takeovers usually don’t work with distressed
firm, but may be best alternative at the
time
Legal Proceedings – Bankruptcy

BANKRUPTCY
Types of legal outcomes
Firm allowed to continue
Firm ceases to exist

Goal: preserve organization value –

restructuring gives firm a chance to
restore financial and operating health
FINANCIAL ENGINEERING STRATEGIES
Use of calls, puts, swaps, forward and future
contracts to influence payoffs
Help limit financial exposure of business firms
as well as of investors
Facilitate merger transactions — can share risk
exposures

LIQUIDATIONS AND TAKEOVER BUST-UPS

Liquidation characteristics
Involuntary – creditors force firm to liquidate
Voluntary – shareholders may receive more if
firm sold in parts

Empirical studies
Large positive returns to voluntary
liquidations (+10 to 15%) – can sell assets
to firms with higher valued uses
Acquiring firm has small, insignificant
positive returns
Executive ownership and executive
compensation incentives increase
probability of liquidation – compensation
plans may motivate managers to shrink
firm’s asset, sometimes costing own jobs