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Financial Distress

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A firm that defaults on a required payment may be forced to liquidate its assets. ... like consensual plans (they don't clog the court calendar with appeals) and ... – PowerPoint PPT presentation

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Title: Financial Distress


1
Financial Distress
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.

3
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
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
Insolvency
  • Stock-base insolvency the value of the firms
    assets is less than the value of the debt.

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

Firm cash flow
7
Why firms suffer financial distress?
  • Firms with too high leverage ratio
  • Firms with inferior operating results
  • Firms in a declining industry

8
Largest U.S. Bankruptcies
Firm Liabilities (in millions) Date
Conseco Inc. 56,639.30 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
9
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.

10
What Happens in Financial Distress
Financialdistress
11
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.

12
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.

13
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.

14
Bankruptcy Liquidation Priority of Claims
  • The distribution of the proceeds of liquidation
    occurs according to the following priority (APR)
  • 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.

15
APR (Absolute Priority Rule) 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.

16
APR (Absolute Priority Rule) Example
  • Under APR, all creditors are paid before
    shareholders, and the mortgage bondholders are
    first in line. The trustee proposes the following
    distribution

17
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.

18
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.

19
Reorganization Example
  • The firm has proposed the following
    reorganization plan

20
Reorganization Example
  • And a distribution of new securities under a new
    claim with the reorganization plan

21
Absolute Priority Rule in Practice
22
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.

23
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.

24
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.

25
Private Workout or Bankruptcy Which is Best?
  • 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.
  • Disadvantages of Bankruptcy
  • A long and expensive process.
  • Judges are required to approve major business
    decisions.
  • Distraction to management.
  • Hold out by stockholders.

26
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.

27
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.

28
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