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Corporate Finance Ross Westerfield Jaffe Sixth Edition

31Chapter Thirty One

Financial Distress

Prepared by

Gady JacobyUniversity of Manitoba

and

Sebouh AintablianAmerican University of Beirut

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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.

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Chapter Outline

31.1 What is Financial Distress?

31.2 What Happens in Financial Distress?

31.3 Bankruptcy Liquidation and Reorganization

31.4 Current Issues in Financial Distress

31.5 The Decision to Seek Court Protection: The Case of Olympia and York

31.6 Summary and Conclusions

Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model

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31.1 What is Financial Distress?

• A situation where a firm’s 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.

• Usually the firm is forced to take actions that it would not have taken if it had sufficient cash flow.

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Insolvency• Stock-base insolvency; the value of the firm’s assets is less than

the value of the debt.

Assets

Debt

Equity

Solvent firm

Debt

AssetsEquity

Insolvent firm

Debt

Note the negative equity

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Insolvency• Flow-base insolvency occurs when the firms cash flows are

insufficient to cover contractually required payments.

Contractual obligations

Insolvency

$

Firm cash flow

Cash flow shortfall

time

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The Largest U.S. Bankruptcies Firm Liabilities ($m) Bankruptcy Date

Texaco $21,603 1987

Executive Life Insurance 14,577 1991

Mutual Benefit Life 13,500 1991

Campeau 9,947 1990

First Capital Holdings 9,291 1991

Baldwin United 9,000 1983

Continental Airlines (II) 6,200 1990

Lomas Financial 6,127 1989

Macy’s 5,300 1992

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31.2 What Happens in Financial Distress?

• Financial distress does not usually result in the firm’s 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.

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What Happens in Financial Distress

Financialdistress

Financialrestructuring

No financialrestructuring

Legal bankruptcy

Privateworkout

Financialdistress

Financialdistress

Reorganize and emerge

Reorganize and emerge

Merge with another firm

Liquidation

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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.

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31.3 Bankruptcy Liquidation and Reorganization

• Firms that cannot meet their obligations have two choices: liquidation or reorganization.

• Liquidation 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 is the option of keeping the firm a going concern.– Reorganization sometimes involves issuing new

securities to replace old ones.

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Bankruptcy Liquidation

Straight liquidation usually involves:1. 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.

2. 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 firm’s assets.

3. After the assets are sold, after payment of the costs of administration, money is distributed to the creditors.

4. If any money is left over, the shareholders get it.

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Bankruptcy Liquidation: Priority of ClaimsThe distribution of the proceeds of liquidation occurs according

to the following priority:1. Administration expenses associated with liquidation.

2. Other expenses arising after the filing of an involuntary bankruptcy petition.

3. Wages, salaries and commissions.

4. Municipal tax claims.

5. Rent.

6. Claims resulting from employee injuries.

7. Unsecured creditors.

8. Preferred shareholders.

9. Common shareholders.

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Example

• Suppose the B.O. Drug Co. decides to liquidate.• 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.

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Example (continued)

Following our list of priorities, 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 $10,000,000 $ 0 Total $14,000,000 $2,500,000

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Bankruptcy Reorganization:

A typical sequence:1. A voluntary petition can be filed by the corporation or an

involuntary petition can be filed by creditors.

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 required to submit a reorganization plan.

5. Creditors and shareholders are divided into classes.

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.

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Reorganization Example

• Suppose the B.O. Drug Co. decides to reorganize under the Bankruptcy and Insolvency Act.

• Assume that the “going concern” value is $3 million and its balance sheet is shown.

Assets $3,000,000 Liabilities:  

    Mortgage bonds $1,500,000

    Subordinated debentures

$2,500,000

   Equity -$1,000,000

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Reorganization Example

The firm has proposed the following reorganization plan:

Old Security Old Claim New Claim Under Reorganization

Mortgage bonds $1,500,000 $1,500,000

Subordinated debentures

$2,500,000 $1,000,000

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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

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31.4 Current Issues in Financial Distress

• 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.

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Private Workout or Bankruptcy: Which is Best?• In Canada, the new Bankruptcy and Insolvency

Act has added increased costs and time commitments to the formal bankruptcy proceedings.

• Direct negotiations (private workouts) between creditors and debtors can be expected to increase.

• Bankruptcy is better for equity investors than for creditors because equity investors can usually hold out for a better deal in bankruptcy.

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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.

• 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.

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The Decision to Seek Court Protection: The Case of Olympia and York• Olympia and York (O&Y) was one of the largest

companies in Canada.• On May 14, 1992, O&Y filed for court protection

in Canada under the Companies’ Creditors Arrangement Act.

• The recession of the early 1990s led to a major decline in real estate prices and an increase in vacancy rates.

• O&Y (a highly leveraged company) could not service its debt because of a lack of cash flow.

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The Decision to Seek Court Protection: The Case of Olympia and York (continued)

• Costs of the O&Y restructuring include:1. Direct costs of restructuring.

Legal fees $5.75 million

Accounting fees 2.65 million

Costs of financial advisors 8.50 million

2. Indirect costs of restructuring: management distraction, loss of customers, and loss of reputation.

3. Costs of a complicated financial structure: Conflicts between managers, shareholders, and creditors make reaching a private agreement difficult.

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31.6 Summary and Conclusions

• Financial distress is a situation where a firm’s 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 liquidation or reorganization.

• A hybrid of a private workout and formal bankruptcy is prepackaged bankruptcy.

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Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model

• Many potential lenders use credit scoring models to assess the creditworthiness of prospective borrowers.

• The general idea is to find factors that enable the lenders to discriminate between good and bad credit risks.

• Edward Altman has developed a model using financial statement ratios and multiple discriminant analyses to predict bankruptcy for publicly traded manufacturing firms

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Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model (continued)

• The resultant model is of the form:

Z = 3.3(EBIT/Total assets) + 1.2(Net working capital/Total assets) + 1.0(Sales/Total assets) + 0.6(Market value of equity/Book value of debt) + 1.4(Accumulated retained earnings/Total assets)

where Z is an index of bankruptcy.

• Bankruptcy would be predicted if Z 1.81 and nonbankruptcy if Z 2.99.

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Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model (continued)

• Altman uses a revised model to make it applicable for private firms and non-manufacturers.

• The resulting model is:Z = 6.56(Net working capital/Total assets) + 3.26(Accumulated retained earnings/Total assets)+ 1.05(EBIT/Total assets) + 6.72(Book value of equity/Total liabilities)where Z 1.23 indicates a bankruptcy prediction.1.23 Z 2.90 indicates a grey area,and Z 2.90 indicates no bankruptcy.