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CHAPTER
30
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
Financial Distress
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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.
McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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Chapter Outline
30.1 What is Financial Distress? 30.2 What Happens in Financial Distress? 30.3 Bankruptcy Liquidation and Reorganization 30.4 Private Workout or Bankruptcy: Which is Best? 30.5 Prepackaged Bankruptcy 30.6 Summary and Conclusions
McGraw-Hill/Irwin Corporate Finance, 7/e 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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Insolvency
Stock-base insolvency; the value of the firms assets is less than the value of the debt. Solvent firm Insolvent firm
Debt Debt Equity Debt
Assets Equity
Assets
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Insolvency
Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments.
$
Cash flow shortfall
time
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UAL Corporation
22,164.00
December 2001
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Financial distress
51% 47%
Private workout
Financial restructuring
53% 83%
7%
10%
Liquidation
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Financial Restructuring:
Issuing new securities. Negotiating with banks and other creditors. Exchanging debt for equity. Filing for bankruptcy.
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Reorganization (Chapter 11) 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 under Chapter 7 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 firms 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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4.
5. 6. 7. 8. 9.
Administration expenses associated with liquidation. Unsecured claims arising after the filing of an involuntary bankruptcy petition. Wages earned within 90 days before the filing date, not to exceed $2,000 per claimant. Contributions to employee benefit plans arising with 180 days before the filing date. Consumer claims, not exceeding $900. Tax claims. Secured and unsecured creditors claims. Preferred stockholders claims. Common stockholders claims.
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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APR Example
Suppose the B.O. Drug Co. decides to liquidate under Chapter 7. 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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APR Example
Under APR, 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
$1,500,000 $1,000,000
$1,500,000 $2,500,000
$10,000,000 $14,000,000
$ 0 $2,500,000
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only approval by 1/2 of creditors owning 2/3 of outstanding debt 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 Chapter 11. Assume that the going concern value is $3 million and its balance sheet is shown.
Assets $3,000,000 Liabilities: Mortgage bonds Subordinated debentures Equity
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Reorganization Example
The firm has proposed the following reorganization plan:
Old Security Old Claim New Claim Under Reorganization
$1,500,000
Mortgage bonds
$1,500,000
Subordinated debentures
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$2,500,000
$1,000,000
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Reorganization Example
And a distribution of new securities under a new claim with the reorganization plan:
Old Security Mortgage bonds New Claim Under Reorganization $1,000,000 in 9% subordinated debentures $500,000 in 11% subordinated debentures $1,000,000 in 8% preferred stock $500,000 in common stock
2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
Subordinated debentures
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Unsecured creditors
Secured creditors
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Advantages of Bankruptcy
1. 2. 3. 4. 5. New credit is available - "debtor in possession" or "DIP" debt. Discontinued accrual of interest on pre-bankruptcy unsecured debt. An automatic stay provision. Tax advantages. Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt. A long and expensive process. Judges are required to approve major business decisions. Distraction to management. Hold out by stockholders.
Disadvantages of Bankruptcy
1. 2. 3. 4.
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Corporate bankruptcy involves Chapter 7 liquidation or Chapter 11 reorganization. An essential feature of the U.S. Bankruptcy code is the absolute priority rule (APR).
A hybrid of a private workout and formal bankruptcy is prepackaged bankruptcy.