30-1

CHAPTER

30

Financial
Distress
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

30-2

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

30-3

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

30-4

30.1 What is Financial Distress?

A situation where a firms operating cash flows
are not sufficient to satisfy current obligations
and the firm is forced to take corrective action.
Financial distress may lead a firm to default on a
contract, and it may involve financial
restructuring between the firm, its creditors, and
its equity investors.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

30-5

Insolvency
Stock-base insolvency; the value of the firms assets is
less than the value of the debt.
Solvent firm
Insolvent firm
Debt
Assets

Assets

Debt
Equity
Debt

Equity

Note the negative equity

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

30-6

Insolvency
Flow-base insolvency occurs when the firms cash flows
are insufficient to cover contractually required payments.
$
Cash flow
shortfall

Contractual
obligations
Firm cash flow
Insolvency
McGraw-Hill/Irwin
Corporate Finance, 7/e

time

2005 The McGraw-Hill Companies, Inc. All Rights

30-7

Largest U.S. Bankruptcies

Firm
Conseco Inc.

Liabilities
(in $ millions)
$56,639.30

Date
December 2002

Worldcom Inc.

45,984.00

July 2002

Enron Corp.

31,237.00

December 2001

Pacific Gas & Electric

Co.

25,717.00

April 2001

UAL Corporation

22,164.00

December 2001

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

30-8

30.2 What Happens in Financial Distress?

Financial distress does not usually result in the firms
death.
Firms deal with distress by
Selling major assets.
Merging with another firm.
Reducing capital spending and research and development.
Issuing new securities.
Negotiating with banks and other creditors.
Exchanging debt for equity.
Filing for bankruptcy.
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

30-9

What Happens in Financial Distress

No financial
restructuring
49%

Private
workout

Financial
distress
51%

47%

Financial
restructuring

Reorganize
and emerge
83%

53%

Legal bankruptcy
Chapter 11

7%

Merge with
another firm

10%
Source: Karen H. Wruck, Financial Distress: Reorganization and Organizational Efficiency, Journal of Financial Economics
27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, Troubled Debt Restructurings: An Empirical
Study of Private Reorganization in Firms in Defaults, Journal of Financial Economics 27 (1990); and Lawrence A. Weiss,
Bankruptcy Resolution: Direct Costs and Violation of Priority Claims, Journal of Financial Economics 27 (1990).

McGraw-Hill/Irwin
Corporate Finance, 7/e

Liquidation

2005 The McGraw-Hill Companies, Inc. All Rights

3010

Responses to Financial Distress

Think of the two sides of the balance sheet.
Asset Restructuring:
Selling major assets.
Merging with another firm.
Reducing capital spending and R&D spending.

Financial Restructuring:
Issuing new securities.
Negotiating with banks and other creditors.
Exchanging debt for equity.
Filing for bankruptcy.
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3011

30.3 Bankruptcy Liquidation

and Reorganization
Firms that cannot meet their obligations have two choices:
liquidation or reorganization.
Liquidation (Chapter 7) means termination of the firm as a going
concern.
It involves selling the assets of the firm for salvage value.
The proceeds, net of transactions costs, are distributed to creditors in order
of priority.

Reorganization (Chapter 11) is the option of keeping the firm a

going concern.
Reorganization sometimes involves issuing new securities to replace old
ones.
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3012

Bankruptcy Liquidation

Straight liquidation under Chapter 7 usually involves:

1. A petition is filed in a federal court. The debtor firm could

2.

3.
4.

file a voluntary petition or the creditors could file an

involuntary petition against the firm.
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.
After the assets are sold, after payment of the costs of
administration, money is distributed to the creditors.
If any money is left over, the shareholders get it.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3013

Bankruptcy Liquidation: Priority of Claims

The distribution of the proceeds of liquidation occurs according to

the following priority:
1.
2.
3.
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.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3014

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.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3015

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

Mortgage Bonds

$1,500,000

$1,500,000

Subordinated
Debentures

$2,500,000

$1,000,000

Common Stock
Total

$10,000,000
$14,000,000

$
0
$2,500,000

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3016

Bankruptcy Reorganization: Chapter 11

A typical sequence:
1. A voluntary petition or an involuntary petition is filed.
2. A federal judge either approves or denies the petition.
3. In most cases the debtor continues to run the business.
4. The firm is given 120 days to submit a reorganization plan.
5. Creditors and shareholders are divided into classes. Requires

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.
McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3017

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

McGraw-Hill/Irwin
Corporate Finance, 7/e

$1,500,000

Subordinated
debentures

$2,500,000

Equity

$1,000,000

2005 The McGraw-Hill Companies, Inc. All Rights

3018

Reorganization Example

The firm has proposed the following reorganization

plan:
Old Security

Old Claim

Mortgage bonds

$1,500,000

$1,500,000

Subordinated
debentures

$2,500,000

$1,000,000

McGraw-Hill/Irwin
Corporate Finance, 7/e

New Claim Under

Reorganization

2005 The McGraw-Hill Companies, Inc. All Rights

3019

Reorganization Example

And a distribution of new securities under a new

claim with the reorganization plan:
Old Security

New Claim Under Reorganization

Mortgage bonds

$1,000,000 in 9% subordinated
debentures
$500,000 in 11% subordinated
debentures

Subordinated debentures

$1,000,000 in 8% preferred stock

$500,000 in common stock

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3020

Absolute Priority Rule in Practice

The APR states that senior claims are fully satisfied before
junior claims receive anything

Deviations from APR

Equityholders

Expectation: No payout
Reality: Payout in 81% of cases

Unsecured creditors

Expectation: Full payout after

secured creditors
Reality: Violation in 78% of cases

Secured creditors

Expectation: Full payout

Reality: Full payout in 92% of
cases

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3021

Reasons for APR Violations

Creditors want to avoid the expense of litigation.
Debtors are given a 120-day window of opportunity to
cause delay and harm value.
Managers often own equity and demand to be
compensated. They are in charge for at least the next
120 days.
Bankruptcy judges like consensual plans (they dont
clog the court calendar with appeals) and pressure
parties to compromise.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3022

Vulture (not Venture) Capital

Vultures are money managers that specialize in the
securities of distressed and defaulted companies.
There are between 50 and 60 institution vulture
specialists, actively managing over $25 billion.
Distressed debt investors have target annual rates of
return of 2025 percent.
Although some years are better than others, the overall
annual rate of return has been about 12 percentsimilar
to junk bonds but less than the stock market.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3023

30.4 Private Workout or Bankruptcy:

Which is Best?
Both formal bankruptcy and private workouts involve
exchanging new financial claims for old financial
claims.
Usually senior debt is replaced with junior debt and debt
is replaced with equity.
When they work, private workouts are better than a
formal bankruptcy.
Complex capital structures and lack of information
make private workouts less likely.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3024

30.4 Private Workout or Bankruptcy:

Which is Best?
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.

Disadvantages of Bankruptcy
1.
2.
3.
4.

A long and expensive process.

Judges are required to approve major business decisions.
Distraction to management.
Hold out by stockholders.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3025

30.5 Prepackaged Bankruptcy

Prepackaged Bankruptcy is a combination of a private
workout and legal bankruptcy.
The firm and most of its creditors agree to private
reorganization outside the formal bankruptcy.
After the private reorganization is put together
(prepackaged) the firm files a formal bankruptcy under
Chapter 11).
The main benefit is that it forces holdouts to accept a
bankruptcy reorganization.
Offers many of the advantages of a formal bankruptcy,
but is more efficient.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights

3026

30.6 Summary and Conclusions

Financial distress is a situation where a firms operating cash
flow is not sufficient to cover contractual obligations.
Financial restructuring can be accomplished with a private
workout or formal bankruptcy.
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.

McGraw-Hill/Irwin
Corporate Finance, 7/e

2005 The McGraw-Hill Companies, Inc. All Rights