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CHAPTER 25 Bankruptcy, Reorganization, and Liquidation

 Financial distress process  Federal bankruptcy law  Reorganization  Liquidation Copyright © 2002 Harcourt Inc.

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What are the major causes of business failure? Economic factors industry weakness poor location/product

Financial factors too much debt insufficient capital

Most failures occur because a number of factors combine to make the business unsustainable. Copyright © 2002 Harcourt Inc.

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Do business failures occur evenly over time?  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. Copyright © 2002 Harcourt Inc.

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

 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. Copyright © 2002 Harcourt Inc.

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What key issues must managers face in the financial distress process?  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 (More...) liquidated? Copyright © 2002 Harcourt Inc.

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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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What informal remedies are available to firms in financial distress?  Informal reorganization  Informal liquidation  Why might informal remedies be preferable to formal bankruptcy?  What types of companies are most suitable for informal remedies? Copyright © 2002 Harcourt Inc. All rights reserved.

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Informal Bankruptcy Terminology  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 (More...) eventual payment in full. Copyright © 2002 Harcourt Inc.

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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. Copyright © 2002 Harcourt Inc.

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Describe the following terms related to U.S. bankruptcy law:  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. (More...) Copyright © 2002 Harcourt Inc.

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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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What are the major differences between an informal reorganization and reorganization in bankruptcy?  Informal Reorganization: Less costly Relatively simple to create Typically allows creditors to recover more money and sooner. (More...) Copyright © 2002 Harcourt Inc.

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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.

(More...)

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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. Copyright © 2002 Harcourt Inc.

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What is a prepackaged bankruptcy?  New type of reorganization Combines the advantages of both formal and informal reorganizations. Avoids holdout problems Preserves creditors’ claims Favorable tax treatment.

 Agreement to plan obtained from creditors prior to filing for bankruptcy.  Plan filed with bankruptcy petition. Copyright © 2002 Harcourt Inc.

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List the priority of claims in a Chapter 7 liquidation.  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. (More...) Copyright © 2002 Harcourt Inc.

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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. Copyright © 2002 Harcourt Inc. All rights reserved.  Common stockholders.

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Liquidation Illustration Data (millions of $) Creditor Claims: Accounts payable Notes payable Accrued wages Federal taxes State and local taxes First mortgage Second mortgage Subordinated debentures* *Subordinated to notes payable. Copyright © 2002 Harcourt Inc.

$10.0 5.0 0.3 0.5 0.2 3.0 0.5 4.0 $23.5 (More...) All rights reserved.

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Proceeds from liquidation: From current assets From fixed assets* Total receipts

$14.0 2.5 $16.5

* All fixed assets pledged as collateral to mortgage holders.

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Priority Distribution (millions of $) Creditor Accrued wages Federal taxes Other taxes First mortgage Second mortgage

Claim Distribution Unsatisfied $0.3 0.5 0.2 3.0 0.5 $4.5

$0.3 0.5 0.2 2.5 0.0 $3.5

$0.0 0.0 0.0 0.5 0.5 $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 general creditors. Copyright © 2002 Harcourt Inc. All rights reserved.

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General Creditor Distribution (millions of $) Creditor Accounts payable Notes payable Accrued wages Federal taxes Other taxes First mortgage Second mortgage Sub. deb. a b

Remaining GC Claim $10.0 5.0 0.0 0.0 0.0 0.5 0.5 4.0 $20.0

Initial Distrib.a $6.500 3.250

0.325 0.325 2.600 $13.000

Final Percent Amountb Received $6.500 65.0% 5.000 100.0 0.300 100.0 0.500 100.0 0.200 100.0 2.825 94.2 0.325 65.0 0.850 21.2 $16.500

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

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Other Motivations for Bankruptcy  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 Copyright © 2002 Harcourt Inc.

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Some Criticisms of Bankruptcy Laws  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. Copyright © 2002 Harcourt Inc.

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Chapter 25 Extension

 MDA to predict bankruptcy  Recent business failures

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What is MDA, and how can it be used to predict bankruptcy?  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. Copyright © 2002 Harcourt Inc.

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MDA Illustration  Assume you have the following 1997 data for 12 companies: Current ratio Debt ratio

 Six of the companies (marked by Xs) went bankrupt in 1998 while six (marked by dots) remained solvent. (More...) Copyright © 2002 Harcourt Inc.

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Solvent Firms

. . .

. .

= Solvent X = Bankrupt

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. .

X

X

Discriminant Boundary X

X X

Bankrupt Firms

X

Debt Ratio (More...) All rights reserved.

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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. (More...) Copyright © 2002 Harcourt Inc.

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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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Using MDA To Predict Bankruptcy  Suppose Firm S has CR = 4.0 and DR = 0.40. Then, 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. Copyright © 2002 Harcourt Inc.

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Some Final Points  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. Copyright © 2002 Harcourt Inc.

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