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Financial Distress

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Title: Financial Distress


1
Financial Distress
  • Lecture 5(2)
  • Saeid Samiei
  • Portsmouth Business School

2
Executive Summary
  • This lecture focuses on 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.

3
Lecture Outline
  • What is Financial Distress?
  • What Happens in Financial Distress?
  • Bankruptcy Liquidation and Reorganization
  • Private Workout or Bankruptcy Which is Best?
  • Prepackaged Bankruptcy
  • Summary and Conclusions

4
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.

5
Stock-Base Insolvency
  • Stock-base insolvency the value of the firms
    assets is less than the value of the debt.

Debt
6
Flow-Base Insolvency
  • Flow-base insolvency occurs when the firms cash
    flows are insufficient to cover contractually
    required payments.

Firm cash flow
7
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.

8
What Happens in Financial Distress
Financialdistress
9
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 RD spending.
  • Financial Restructuring
  • Issuing new securities.
  • Negotiating with banks and other creditors.
  • Exchanging debt for equity.
  • Filing for bankruptcy.

10
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.

11
Bankruptcy Liquidation
  • Straight liquidation under Chapter 7 usually
    involves
  • A petition is filed in a federal court. The
    debtor firm could 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.

12
Bankruptcy Liquidation Priority of Claims
  • 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.

13
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 claims
  • After paying this, 2.5 million is available to
    pay creditors.
  • The only problem is that the unpaid debt is 4
    million.

14
APR Example
  • Under APR, all creditors are paid before
    shareholders, and the mortgage bondholders are
    first in line. The trustee proposes the following
    distribution

15
Bankruptcy Reorganization Chapter 11
  • A typical sequence
  • A voluntary petition or an involuntary petition
    is filed.
  • A federal judge either approves or denies the
    petition.
  • In most cases the debtor continues to run the
    business.
  • The firm is given 120 days to submit a
    reorganization plan.
  • Creditors and shareholders are divided into
    classes. Requires only approval by 1/2 of
    creditors owning 2/3 of outstanding debt
  • After acceptance by the creditors, the plan is
    confirmed by the court.
  • Payments in cash, property, and securities are
    made to creditors and shareholders.

16
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.

17
Reorganization Example
  • The firm has proposed the following
    reorganization plan

18
Reorganization Example
  • And a distribution of new securities under a new
    claim with the reorganization plan

19
Absolute Priority Rule in Practice
20
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.

21
Predicting Corporate BankruptcyThe Z-Score model
  • Edward Altman developed a model to predict
    bankruptcy
  • Where Z is an index of bankruptcy.

22
Predicting Corporate Bankruptcy
  • Where
  • Z gt 2.99 indicates no bankruptcy
  • 1.81 Z 2.99 indicates a grey area
  • Z lt 1.81 indicates bankruptcy

23
The Z-Score model Private non-manufacturing
firms
Where Z gt 2.90 indicates no
bankruptcy 1.23 Z 2.90 indicates a grey area
Z lt 1.23 indicates bankruptcy
24
Vultures
  • 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
    in 1998.
  • 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 from 1978-1997 has
    been about 12 percentsimilar to junk bonds but
    less than the stock market.

25
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.

26
Advantages of Bankruptcy
  • 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.

27
Disadvantages of Bankruptcy
  • A long and expensive process.
  • Judges are required to approve major business
    decisions.
  • Distraction to management.
  • Hold out by stockholders.

28
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.

29
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.
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