24 - 1

CHAPTER 24
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 firms
ability to pay.
Extension: Creditors postpone the
dates of required interest or principal
payments, or both. Creditors prefer
extension because they are promised
(More...)
eventual payment in full.

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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 firms assets. Title
to the debtors assets is transferred
to a third party, called a trustee or
assignee, and then the assets are
sold off.

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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
firms management.
Involuntary bankruptcy: A
bankruptcy petition filed in
federal court by the distressed
firms 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.
Trustees 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 stockholders.

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Liquidation Illustration Data

(millions of $)
Creditor Claims:
Accounts payable
Notes payable
Accrued wages
Federal taxes
State and local taxes
First mortgage
Second mortgage
Subordinated debentures*
*Subordinated to notes payable.

$10.0
5.0
0.3
0.5
0.2
3.0
0.5
4.0
$23.5
(More...)

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Proceeds from liquidation:

From current assets
From fixed assets*
Total receipts

$14.0
2.5
$16.5

* All fixed assets pledged as collateral to mortgage

holders.

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Priority Distribution
(millions of $)
Creditor
Accrued wages
Federal taxes
Other taxes
First mortgage
Second mortgage

Claim Distribution Unsatisfied

$0.3
0.5
0.2
3.0
0.5
$4.5

$0.3
0.5
0.2
2.5
0.0
$3.5

$0.0
0.0
0.0
0.5
0.5
$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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General Creditor Distribution (millions of $)

Creditor
Accounts payable
Notes payable
Accrued wages
Federal taxes
Other taxes
First mortgage
Second mortgage
Sub. deb.
a
b

Remaining
GC Claim
$10.0
5.0
0.0
0.0
0.0
0.5
0.5
4.0
$20.0

Initial
Distrib.a
$6.500
3.250

0.325
0.325
2.600
$13.000

Final
Percent
Amountb Received
$6.500
65.0%
5.000
100.0
0.300
100.0
0.500
100.0
0.200
100.0
2.825
94.2
0.325
65.0
0.850
21.2
$16.500

Pro rata amount = $13/$20 = 0.65.

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 24 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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MDA Illustration
Assume you have the following
2003 data for 12 companies:
Current ratio
Debt ratio

Six of the companies (marked by

Xs) went bankrupt in 2004 while six
(marked by dots) remained solvent.
(More...)

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Current Ratio

Solvent
Firms

.
.
.

.
.

.
.

= Solvent
X = Bankrupt

Discriminant
Boundary
X

X
X

Bankrupt
Firms

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.

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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 Altmans
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.