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Financial distress process

Federal bankruptcy lawReorganizationLiquidation

CHAPTER 24Bankruptcy, Reorganization,

and Liquidation

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Economic factorsindustry weaknesspoor location/product

Financial factorstoo much debtinsufficient capital

Most failures occur because a number of factors combine to make the business unsustainable.

What are the major causesof business failure?

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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.

Do business failures occur evenly over time?

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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.

What size firm, large or small, is more prone to business failure?

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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?

What key issues must managers face in the financial distress process?

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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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Informal reorganization

Informal liquidation

Why might informal remedies be preferable to formal bankruptcy?

What types of companies are most suitable for informal remedies?

What informal remedies are available to firms in financial distress?

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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.

Informal Bankruptcy Terminology

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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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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.

Describe the following terms related to U.S. bankruptcy law:

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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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Informal Reorganization:

Less costly

Relatively simple to create

Typically allows creditors to recover more money and sooner.

What are the major differencesbetween an informal reorganizationand reorganization in bankruptcy?

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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.

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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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New type of reorganizationCombines the advantages of both formal

and informal reorganizations.Avoids holdout problemsPreserves creditors’ claims Favorable tax treatment.

Agreement to plan obtained from creditors prior to filing for bankruptcy.

Plan filed with bankruptcy petition.

What is a prepackaged bankruptcy?

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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.

List the priority of claims in aChapter 7 liquidation.

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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 $10.0Notes payable 5.0Accrued wages 0.3Federal taxes 0.5State and local taxes 0.2First mortgage 3.0Second mortgage 0.5Subordinated debentures* 4.0

$23.5*Subordinated to notes payable.

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Proceeds from liquidation:From current assets $14.0From fixed assets* 2.5Total receipts $16.5

* All fixed assets pledged as collateral to mortgage holders.

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Creditor Claim Distribution UnsatisfiedAccrued wages $0.3 $0.3 $0.0Federal taxes 0.5 0.5 0.0Other taxes 0.2 0.2 0.0First mortgage 3.0 2.5 0.5Second 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 generalcreditors.

Priority Distribution(millions of $)

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Remaining Initial Final PercentCreditor GC Claim Distrib.a Amountb ReceivedAccounts payable $10.0 $6.500 $6.500 65.0%Notes payable 5.0 3.250 5.000 100.0Accrued wages 0.0 0.300 100.0Federal taxes 0.0 0.500 100.0Other taxes 0.0 0.200 100.0First mortgage 0.5 0.325 2.825 94.2Second mortgage 0.5 0.325 0.325 65.0Sub. deb. 4.0 2.600 0.850 21.2

$20.0 $13.000 $16.500

General Creditor Distribution (millions of $)

a Pro rata amount = $13/$20 = 0.65.b Includes priority distribution and $1.75 transfer from

subordinated debentures.

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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

Other Motivations for Bankruptcy

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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.

Some Criticisms of Bankruptcy Laws

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Chapter 24 Extension

MDA to predict bankruptcyRecent business failures

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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.

What is MDA, and how can it be used to predict bankruptcy?

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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.

MDA Illustration

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Current Ratio

Debt Ratio

.. .

.

. . XX

X

X

X

X

Discriminant Boundary

BankruptFirms

SolventFirms

(More...)= Solvent

X = Bankrupt.

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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.

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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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Suppose Firm S has CR = 4.0 and DR = 0.40. Then,

Using MDA To Predict Bankruptcy

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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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.

Some Final Points