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CHAPTER 25
Bankruptcy, Reorganization,
and Liquidation

 Financial distress
process
 Federal bankruptcy law
 Reorganization
 Liquidation
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What are the major causes


of business failure?
Economic factors
industry weakness
poor location/product
Financial factors
too much debt
insufficient capital
Most failures occur because a
number of factors combine to make
the business unsustainable.
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Do business failures occur evenly


over time?

 A large number of businesses fail


each year, but the number in any
one year has never been a large
percentage of the total business
population.
 The failure rate of businesses has
tended to fluctuate with the state of
the economy.
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What size firm, large or small, is more


prone to business failure?

 Bankruptcy is more frequent among


smaller firms.
 Large firms tend to get more help
from external sources to avoid
bankruptcy, given their greater
impact on the economy.

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What key issues must managers


face in the financial distress process?
 Is it a temporary problem (technical
insolvency) or a permanent problem
caused by asset values below debt
obligations (insolvency in
bankruptcy)?
 Who should bear the losses?
 Would the firm be more valuable if it
continued to operate or if it were
liquidated? (More...)
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 Should the firm file for bankruptcy,


or should it try to use informal
procedures?
 Who would control the firm during
liquidation or reorganization?

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What informal remedies are available


to firms in financial distress?

 Informal reorganization
 Informal liquidation
 Why might informal remedies be
preferable to formal bankruptcy?
 What types of companies are
most suitable for informal
remedies?
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Informal Bankruptcy Terminology

 Workout: Voluntary informal


reorganization plan.
 Restructuring: Current debt terms
are revised to facilitate the firm’s
ability to pay.
Extension: Creditors postpone the
dates of required interest or principal
payments, or both. Creditors prefer
extension because they are promised
eventual payment in full. (More...)
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Composition: Creditors voluntarily


reduce their fixed claims on the debtor
by either accepting a lower principal
amount or accepting equity in lieu of
debt repayment.
 Assignment: An informal procedure
for liquidating a firm’s assets. Title
to the debtor’s assets is transferred
to a third party, called a trustee or
assignee, and then the assets are
sold off.
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25 - 10

Describe the following terms related to


U.S. bankruptcy law:
 Chapter 11: Business reorganization
guidelines.
 Chapter 7: Liquidation procedures.
 Trustee:
 Appointed to control the company when
current management is incompetent or
fraud is suspected.
Used only in unusual circumstances.
(More...)
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 Voluntary bankruptcy: A
bankruptcy petition filed in
federal court by the distressed
firm’s management.
 Involuntary bankruptcy: A
bankruptcy petition filed in
federal court by the distressed
firm’s creditors.

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What are the major differences


between an informal reorganization
and reorganization in bankruptcy?

 Informal Reorganization:
Less costly
Relatively simple to create
Typically allows creditors to recover
more money and sooner.
(More...)
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 Reorganization in Bankruptcy
Avoids holdout problems.
Due to automatic stay provision,
avoids common pool problem.
Interest and principal payments
may be delayed without penalty
until reorganization plan is
approved.
(More...)
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Permits the firm to issue debtor in


possession (DIP) financing.
Gives debtor exclusive right to
submit a proposed reorganization
plan for agreement from the parties
involved.
Reduces fraudulent conveyance
problem.
Cramdown if majority in each
creditor class approve plan.
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What is a prepackaged bankruptcy?

 New type of reorganization


Combines the advantages of both formal
and informal reorganizations.
Avoids holdout problems
Preserves creditors’ claims
Favorable tax treatment.
 Agreement to plan obtained from
creditors prior to filing for bankruptcy.
 Plan filed with bankruptcy petition.
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List the priority of claims in a


Chapter 7 liquidation.

 Secured creditors.
 Trustee’s administrative costs.
 Expenses incurred after involuntary
case begun but before trustee
appointed.
 Wages due workers within 3 months
prior to filing. (More...)
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 Unpaid contributions to employee


benefit plans that should have
been paid within 6 months prior to
filing.
 Unsecured claims for customer
deposits.
 Taxes due.
 Unfunded pension plan liabilities.
 General (unsecured) creditors.
 Preferred stockholders.
 Common
Copyright stockholders.
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Liquidation Illustration Data


(millions of $)
Creditor Claims:
Accounts payable $10.0
Notes payable 5.0
Accrued wages 0.3
Federal taxes 0.5
State and local taxes 0.2
First mortgage 3.0
Second mortgage 0.5
Subordinated debentures* 4.0
$23.5
*Subordinated to notes payable.
(More...)
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Proceeds from liquidation:


From current assets $14.0
From fixed assets* 2.5
Total receipts $16.5

* All fixed assets pledged as collateral to mortgage


holders.

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Priority Distribution
(millions of $)
Creditor Claim Distribution Unsatisfied
Accrued wages $0.3 $0.3 $0.0
Federal taxes 0.5 0.5 0.0
Other taxes 0.2 0.2 0.0
First mortgage 3.0 2.5 0.5
Second mortgage 0.5 0.0 0.5
$4.5 $3.5 $1.0

Notes: (1) First mortgage receives entire proceeds from sale of


fixed assets, leaving $0 for the second mortgage.
(2) $16.5 - $3.5 = $13.0 remains for distribution to general
creditors.
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25 - 21

General Creditor Distribution (millions of $)


Remaining Initial Final Percent
Creditor GC Claim Distrib.a Amountb Received
Accounts payable $10.0 $6.500 $6.500 65.0%
Notes payable 5.0 3.250 5.000 100.0
Accrued wages 0.0 0.300 100.0
Federal taxes 0.0 0.500 100.0
Other taxes 0.0 0.200 100.0
First mortgage 0.5 0.325 2.825 94.2
Second mortgage 0.5 0.325 0.325 65.0
Sub. deb. 4.0 2.600 0.850 21.2
$20.0 $13.000 $16.500
a
Pro rata amount = $13/$20 = 0.65.
b
Includes priority distribution and $1.75 transfer from
subordinated debentures.
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Other Motivations for Bankruptcy

 Normally, bankruptcy is motivated by


serious current financial problems.
 However, some companies have used
bankruptcy proceedings for other
purposes:
To break union contracts
To hasten liability settlements

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Some Criticisms of Bankruptcy Laws

 Critics contend that current (1978)


bankruptcy laws are flawed.
 Too much value is siphoned off by
lawyers, managers, and trustees.
 Companies that have no hope remain
alive too long, leaving little for
creditors when liquidation does occur.
 Companies in bankruptcy can hurt
other companies in industry.
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Chapter 25 Extension

 MDA to predict bankruptcy


 Recent business failures

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What is MDA, and how can it be used


to predict bankruptcy?

 Multiple discriminant analysis (MDA)


is a statistical technique similar to
multiple regression.
 It identifies the characteristics of
firms that went bankrupt in the past.
 Then, data from any firm can be
entered into the model to assess the
likelihood of future bankruptcy.
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25 - 26

MDA Illustration

 Assume you have the following


1997 data for 12 companies:
Current ratio
Debt ratio
 Six of the companies (marked by
Xs) went bankrupt in 1998 while six
(marked by dots) remained solvent.
(More...)
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Current Ratio Discriminant

. . Boundary

Solvent
Firms
. .
X

. . X

X
X
X
X Bankrupt
Firms

. = Solvent
X = Bankrupt
Debt Ratio

(More...)

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 The discriminant boundary, or Z line,


statistically separates the bankrupt
and solvent companies.
 Note that two companies have been
misclassified by the MDA program:
One bankrupt company falls on the
solvent (left) side and one solvent
company falls on the bankrupt (right)
side.
(More...)
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 Assume the equation for the


boundary line is
Z = -2 + 1.5(Current ratio) - 5.0(Debt ratio).

 Furthermore, if Z = -1 to +1, the


future of the company is uncertain.
If Z > 1, bankruptcy is unlikely; if Z <
-1, bankruptcy is likely to occur.

Copyright © 2002 Harcourt Inc. All rights reserved.


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Using MDA To Predict Bankruptcy

 Suppose Firm S has CR = 4.0 and


DR = 0.40. Then,
Z = -2 + 1.5(4.0) - 5.0(0.40) = +2.0,
and firm is unlikely to go bankrupt.
 Suppose Firm B has CR = 1.5 and
DR = 0.75. Then,
Z = -2 + 1.5(1.5) - 5.0(0.75) = -3.5,
and firm is likely to go bankrupt.
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Some Final Points

 The most well-known bankruptcy


prediction model is Edward Altman’s
five factor model.
 Such models tend to work relatively
well, but only for the near term.
 The more similar the historical sample
to the firm being evaluated, the better
the prediction.
Copyright © 2002 Harcourt Inc. All rights reserved.

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