Financial Distress

What we will learn:

1. What is financial distress?
2. What happens in financial distress?
3. Bankruptcy Liquidation and Reorganization
4. Private workout or Bankruptcy: Which is best?
5. Prepackaged Bankruptcy
6. Predicting corporate bankruptcy
 What is Financial Distress?
It is difficult to precisely defined.
Financial distress is a situation where a firm’s operating cash
flows are not sufficient to satisfy current obligations and the firm
is coerced to take corrective action.
Events(symptoms) that usually precede financial distress:
• Dividend reductions
• Plant closings
• Losses
• Layoffs
• CEO resignations
• Plummeting stock prices
 What is Financial Distress?
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.
Insolvency is the symptom of financial distress.
Two types of insolvency:
1. Stock-based insolvency
2. Flow based insolvency
See figure 30.1 on page 929

Insolvency may lead to bankruptcy. (See Table 30.1 on page 929)

 What Happens in Financial Distress?
GM’s case
Lost market shares to rivals such as Toyota, BMW and Honds.
Reported negative income ($15 million) in 2008.
Accumulated SHs’ equity of the company turned negative in
2006.
Share price decreased from $50 in late 2003 to $1 in 2009.
The company struggled to increase sales, cut costs, attempted to
sell assets, drew down bank debt, and arranged for more long-
term financing.
GM filed for bankruptcy in November 2010.
 What Happens in Financial Distress?
Firms deal with financial distress in many ways. Some of include
the following:
1. Selling major assets.
2. Merging with another firm.
3. Reducing capital spending and research and development.
4. Issuing new securities.
5. Negotiating with banks and other creditors.
6. Exchanging for equity.
7. Filing for bankruptcy.
See Figure 30.2 on page 931
 Bankruptcy Liquidation and
Reorganization
Firms that cannot make contractually required payments to
creditors have two basic options:
• Liquidation: Termination of business as a going concern.
• Reorganization: Option of keeping the firm as a going concern;
it sometimes involves issuing new securities to replace old
securities.
Liquidation and formal reorganization may be done by
bankruptcy.
Bankruptcy is a legal proceeding and can be done voluntarily
with the corporation filing the petition or involuntarily with the
creditors filling the petition.
 Bankruptcy Liquidation and
Reorganization
Bankruptcy Liquidation
The sequence of events:
1. A petition is filed in federal court.
2. A bankruptcy trustee is elected by the creditors to take over
the assets of the debtor corporation.
3. When the assets are liquidated, after payment of the costs of
administration, proceeds are distributed to the creditors.
4. If any assets remain after expenses and payments to the
creditors, the are distributed to the shareholders
 Bankruptcy Liquidation and
Reorganization
Conditions Leading to Involuntary Bankruptcy:
1. The corporation is not paying debts as they become due.
2. If there are more than 12 creditors, at least three with claims
totaling $13,475 or more must join in the filling.
 Bankruptcy Liquidation and
Reorganization
Priority of Claims as guided by absolute priority rule (APR)
1. Administration expenses associated with liquidating the bankrupt
company’s assets.
2. Unsecured claims arising after the filing of an involuntary
bankruptcy petition.
3. Wages, salaries, and commissions.
4. Contributions to employee benefit plans arising within 180 days
before the filing date.
5. Consumer claims.
6. Tax claims.
7. Secured and unsecured creditors’ claims.
8. Preferred stockholders’ claims.
9. Common stockholders’ claims.
 Bankruptcy Liquidation and
Reorganization
Liens on property are outside APR ordering.
If secured property is liquidated and provides cash insufficient to
cover the amount owed them, the secured creditors join with
unsecured creditors in dividing the remaining liquidating value.
 Bankruptcy Reorganization
Corporate reorganization takes place under Chapter 11 of the
Federal Bankruptcy Act of 1978, as amended by the Bankruptcy
Prevention and Consumer Protection Act of 2005.
The objective of a proceeding under Chapter 11 is to plan to
restructure the corporation with some provision for repayment
of creditors.
 Bankruptcy Reorganization
A typical sequence of events follows:
1. A petition is filed.
2. A federal judge approves the petition, and a time for filing proofs of
claims of creditors and of shareholders is set.
3. In most cases, the corporation (the “debtor in possession”) continues to
run the business.
4. For 120 days only the corporation can file a reorganization plan. The
corporation is given 180 days to gain acceptance of the plan.
5. A class of creditors accepts the plan if two-thirds of the class (in dollar
amount) and one-half of the class (in number) have indicated approval.
6. After acceptance by the creditors, the plan is confirmed by the court.
7. Payment in cash, property, and securities are made to creditors and
shareholders. The plan may provide for the issuance of new securities.
Private Workout or Bankruptcy: Which
is Best?
In case of default on debt payments, the firm will have two
choices:
Formal Bankruptcy
Private Workout
In case of bankruptcy reorganization and private workout,
exchanging new financial claims for old financial claims is
needed.
Private Workout or Bankruptcy: Which
is Best?
Historically, half of financial restructurings have been private, but
recently, formal bankruptcies have dominated.
Firms that emerge from private workouts experience stock price
increases that are much larger than those for firms emerging
from formal bankruptcies.
The direct costs of private workouts are much less than the costs
of formal bankruptcies.
Top management usually loses pay and sometimes jobs in both
private workouts and formal bankruptcies.
These facts, taken together, seem to suggest that a private
workout is much better than a formal bankruptcy.
Private Workout or Bankruptcy: Which
is Best?
Formal bankruptcy allows firms to issue debt that is senior to all
previously incurred debt. This new debt is “debtor in possession”
(DIP) debt.
For firms that need a temporary injection of cash, DIP debt
makes bankruptcy reorganization attractive.
Bankruptcy is usually better for the equity investors than it is for
creditors. Equity investors can usually hold out for a better deal
in bankruptcy.
Asymmetric information: Equity(Insiders) holders know the company
better. Debt(outsiders) holders always think they are getting less, So
private workout fails.
 Predicting Corporate Bankruptcy
Professor Edward Altman developed a model to predict
bankruptcy for publicly traded manufacturing firms. The model is
given below:

EBIT NWC Sales MV of Equity Acc. R/E

Z = 3.3 + + 1.2 + 1.0 + .6 + 1.4
TA TA TA BV of debt TA
Where Z is an index of bankruptcy.
A score of Z less that 2.675 indicates that a firm has a 95%
chance of becoming bankrupt within one year.