AFM 371 Winter 2008 Chapter 31 - Financial Distress

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1 AFM 371 Winter 2008 Chapter 31 - Financial Distress 1 / 14

2 Outline Background What Happens in Financial Distress? Bankruptcy Liquidation and Reorganization Current Issues in Financial Distress Two Practice Problems From Chapter 16 2 / 14

3 Background as we will see in Chapter 17, financial distress (and its associated costs) has a potentially large impact on capital structure decisions by firms a firm that defaults on a required payment may be forced to liquidate its assets however, more often a defaulting firm will restructure financial restructuring involves replacing old financial claims with new ones and takes place with either private workouts or legal bankruptcy ackground 3 / 14

4 What is Financial Distress? financial distress is a situation where a firm s operating cash flows are insufficient to meet its current obligations (and so the firm must take some kind of 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 shareholders in most cases, the firm is forced to take actions that it would not have taken if it had sufficient cash flow insolvency is a term which generally means an inability to repay debts stock-based insolvency occurs when the value of a firm s assets is less than what is owed on its debt flow-based insolvency occurs when the firm s cash flows are insufficient to cover contractually required payments ackground 4 / 14

5 Stock and Flow-Based Insolvency Stock-Based Insolvency Solvent Firm Insolvent Firm Assets Debt Equity Assets Debt Negative Equity $ Flow-Based Insolvency Contractual obligations Insolvency Firm cash flow Time ackground 5 / 14

6 What Happens in Financial Distress? financial distress does not always result in the termination of the firm (is the firm better alive than dead?) firms deal with financial distress in a variety of ways asset restructuring includes actions such as: selling off assets cutting back R&D and capital spending merging with another firm financial restructuring may involve: cutting dividends issuing new securities negotiating with creditors exchanging debt for equity filing for bankruptcy What Happens in Financial Distress? 6 / 14

7 The U.S. Experience Financial distress 49% No financial restructuring 47% Private workout 51% Financial restructuring 83% Reorganize and emerge 53% Legal bankruptcy 7% Merge with another firm 10% Liquidation hat Happens in Financial Distress? 7 / 14

8 Bankruptcy Liquidation and Reorganization in a legal bankruptcy, firms effectively have two options: liquidation or reorganization liquidation means termination of the firm as a going concern involves selling the assets of the firm for salvage value proceeds are distributed to creditors in order of priority reorganization is the option of keeping the firm as a going concern sometimes involves issuing new securities to replace old ones liquidation usually involves: a petition is filed in court (either voluntarily by the firm or the creditors can file an involuntary petition) a trustee-in-bankruptcy is elected by the creditors to take over the assets of the firm and try to liquidate them after the assets are sold, money is distributed to the creditors (after administrative expenses are paid) any remaining money goes to the shareholders Bankruptcy Liquidation and Reorganization 8 / 14

9 Priority of Claims in Liquidation 1 Administrative expenses associated with liquidation 2 Other expenses arising after the filing of an involuntary bankruptcy petition but prior to the appointment of a trustee 3 Wages, salaries, and commissions 4 Municipal tax claims 5 Rent 6 Claims from employee injuries not covered by workers compensation 7 Unsecured creditors 8 Preferred shareholders 9 Common shareholders note that (i) federal income tax must be paid before any of the above; (ii) secured creditors receive proceeds from sale of the securing assets (if the amount is insufficient, they join this list as unsecured creditors); and (iii) courts have considerable flexibility to deviate from this list ankruptcy Liquidation and Reorganization 9 / 14

10 Liquidation Example consider the example on pp in the text the liquidation value is assumed to be $2.7 million bonds worth $1.5 million are secured by a mortgage on a building, which is sold for $1 million $200,000 is used to cover administrative costs a total of $2.5 million is available to pay creditors the unpaid debt is $4 million following the priority list, the trustee proposes the following distribution Cash Received Type of Claim Prior Claim 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 ankruptcy Liquidation and Reorganization 10 / 14

11 Bankruptcy Reorganization: A Typical Sequence 1 A voluntary petition can be filed in court by the firm or an involuntary petition can be filed by the 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 creditors, the plan is confirmed by the court 7 Payments in cash, property, and securities are made to the creditors and shareholders note that (i) a class of creditors accepts the plan if a majority of the class agrees; (ii) secured creditors vote before unsecured creditors; and (iii) courts have the power to force uncooperative creditors to accept proposals ankruptcy Liquidation and Reorganization 11 / 14

12 Reorganization Example consider the example on pp in the text assume that the going concern value is $3 million and that the balance sheet is: Assets $3,000,000 Liabilities Mortgage bonds $1,500,000 Subordinated debentures $2,500,000 Shareholders equity -$1,000,000 the firm has proposed a re-organization plan: Old Security Old Claim New Claim Mortgage bonds $1,500,000 $1,500,000 Subordinated debentures $2,500,000 $1,000,000 the proposed distribution of securities is: Old Security Mortgage bonds Subordinated debentures New Claim $1,000,000 in 9% subordinated debentures $500,000 in 11% subordinated debentures $1,000,000 in 8% preferred stock $500,000 in common stock ankruptcy Liquidation and Reorganization 12 / 14

13 Current Issues in Financial Distress liquidation or reorganization are two formal bankruptcy procedures an alternative is a private workout, which is a reorganization involving direct negotiations between creditors and debtors in a private workout, usually senior debt is replaced by junior debt and debt is replaced with equity when they work, private workouts are better than a formal bankruptcy (direct costs are only about 10% of a bankruptcy) a firm with a more complicated capital structure will have more trouble arranging a private workout bankruptcy is usually better for equity investors because they can typically hold out for a better deal (courts violate strict priority) a prepackaged bankruptcy is a combination of a private workout and a formal bankruptcy the firm and most creditors agree to a private reorganization the firm then files a formal bankruptcy idea is to use the courts to force holdouts to agree to a reorganization urrent Issues in Financial Distress 13 / 14

14 Two Practice Problems From Chapter 16 1 Companies A and B differ only in their capital structure. A is financed by 30% debt and 70% equity; B is financed by 10% debt and 90% equity. The debt of both companies is risk free. Assume that there are no taxes. (a) Mr. X owns 1% of the common stock of A. What other investment package would produce identical cash flows for him? (b) Ms. Y owns 2% of the common stock of B. What other investment package would produce identical cash flows for her? (c) Show that neither Mr. X nor Ms. Y would invest in the common stock of B, if the total value of company A were less than that of B. 2 U and L are two firms which are identical in all relevant aspects except that U is unlevered whereas L has $30 million of perpetual 9% debt. Assume that the EBIT and corporate tax rate for the firms are $8 million (perpetual) and 40% respectively, and the cost of capital for U is 12%. (a) What value would MM place on each of these firms? What is the expected return on L s equity? (b) Suppose that the market is not in equilibrium, so that V U = $38 million and V L = $44 million, instead of the MM values. Consider an investor who owns 3% of the shares of U. What dollar return will this investor receive? Describe in detail an alternative investment strategy involving ownership of 3% of the shares of L which produces the same dollar return at lower cost. The existence of this alternative strategy represents an arbitrage opportunity. As an investor, how could you exploit this opportunity? wo Practice Problems From Chapter / 14

Capital Structure. Balance-sheet Model of the Firm

Capital Structure. Balance-sheet Model of the Firm Capital Structure Topics Debt vs. Equity Contingent Claims MM Proposition Capital structure without taxes Capital structure with taxes Financial Distress Bankruptcy costs Indirect financial distress costs