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Douglas G. Baird & Randal C. Picker The University of Chicago Law School Firm Valuations and Real Options The Shutdown Decision in Chapter 11

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker2 The Shutdown Decision in Chapter 11 A firm enters Chapter 11 as an operating business At one or more points, someone asks the judge to pull the plug How should the judge approach this question?

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker3 The Shutdown Decision in Chapter 11 Timing is everything Shut down the firm too soon, and a viable business is lost forever Wait too long, and you have made a bad situation worse

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker4 The Shutdown Decision in Chapter 11 Judges must make the right decision at the right time The judge is exercising what economists call a “real option” This “real options” idea should be incorporated into net present value calculations It provides a powerful intuition for analyzing many issues in Chapter 11

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker5 Measuring Present Value Casual net present value calculations assume that you have to make an up-or- down decision today The ability to wait itself affects the net present value calculations in Chapter 11 and elsewhere

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker6 Hypo Creditors $100 “We can sell the assets for $100.” Debtor Firm “If we operate …” “and we do poorly, we are worth $80.” “and we do well, we are worth $250.” 10%90%

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker7 Should We Liquidate the Firm? “Casual” Net Present Value Calculation Assume 10% Interest Rate 10% x $250 = $25 90% x $80 = $72 Expected Total = $97 Present Value = $97/1.1 = $88 Operating the Firm $100 Liquidate

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker8 Wrong! Ignores Choices and Benefits of More Info Try a Different Approach Key Assumption: After operating one period, firm can still be liquidated for $100 Operating does not reduce liquidation value Think of perhaps real estate or intellectual property

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker9 Better NPV Calculation Succeeds: 10% x $250 = $25 Fails: 90% x $100 = $90 Expected Total = $115 Present Value = $115/1.1 = $105 Operating One Period $100 Liquidate If bad operations, liquidate instead

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker10 Controlling Timing v. Now-or- Never Decisions The Now-or-Never Decision Liquidate Now with NPV of $100 The Value of a One-Period Option to Wait $4.54 By operating the firm for one period, we increase PV by $4.54 We gain info, and learn whether the firm can succeed

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker11 From The Paper “Some firms should be kept intact even though the expected earnings of the firm over time are less than the cash that can be realized from the piecemeal sale of its assets today.”

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker12 Core Idea “Sample” operations to try to grab the high end of the distribution and, if not, exit to liquidation Sampling requires waiting Waiting is costly, even when the assets don’t decline in value But uncertainty makes some waiting desirable

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker13 Searching for the Perfect Cup of Coffee Price for Coffee: $6 Store A Store B Store C Store D We know, but X doesn’t know, that the coffee is worth at A: $10, B: $9, C: $8, D: $7 X knows distribution of values It costs X $1 to visit a store Return to store for free

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker14 What Should X Do? X should go to at least one store Worst outcome is find coffee worth $7 Pay $6 for coffee + $1 for search and break even 3 of 4 times find coffee worth 8, 9 or 10 and do better than that

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker15 When Should X Stop? X finds A in 1 st Search Suppose X stumbles on to A in her first search and finds coffee worth $10 X cannot do better than A She should should stop, pay $6, plus $1 search cost, and be $3 to the good

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker16 Suppose X finds B in 1 st Search X has coffee worth $9 in hand X could only do better by finding store A, with coffee worth $10 She would have to pay $1 to look again, and could gain only $1, and 2/3 of the time she will not find A on her next search X should stop if she finds B in her first search

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker17 Suppose X finds C in 1 st Search X has coffee worth $8 in hand X could only do better by finding store A or B, with coffee worth $10 or $9 The cost of another search is $1 The expected gain is (1/3) x $2 + (1/3) x $1 + (1/3) x $0 = $1 She is indifferent between searching and not searching?

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker18 Wrong! After we find D on the second search, we know where A and B are and have the option to search again. Once we know C and D, the expected gain from searching is (1/2) x 2 + (1/2) x 1 = 1.5 The cost is 1, so the expected net gain from the search is 0.5 So our calculation for C is (1/3) x $2 + (1/3) x $1 + (1/3) x $0.50 = 1.16 against a cost of $1, so we should search again if we find C on the first search

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker19 Suppose X find D in 1 st Search X has coffee worth $7 in hand X knows she will do better by going to another store. The cost of another search is $1 The expected gain is (1/3) x $3 + (1/3) x $2 + (1/3) x $??? > $1 X should should look again if she finds D

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker20 Search Rule So Far Undertake first search If find A or B, stop If find C or D, search again

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker21 The Rest of the Search Rule After Finding C or D in First Search, in Second Search If X finds A or B, stop. If X finds C or D, expected gain from further search is (1/2) x 2 + (1/2) x 1 or 1.5, so search again After Finding C or D in Second Search, after Third Search Stop

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker22 Tying this to Bankruptcy and Shutdown Decisions The bankruptcy judge is presented with a proposed disposition of the assets of the estate What is the likely distribution of better proposals? What is the cost of considering each proposal? When should the judge stop considering proposals?

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker23 Pricing the Option to Wait We wait to learn; if we are certain, there is nothing to learn, and no reason to wait The more uncertainty—the more volatility—associated with the operations of the firm, the more valuable it is to wait The Black-Scholes Option Pricing Formula gives us a formal way to value real options But we don’t have the same amount of information that exists for financial options

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker24 Real Options in Chapter 11 What is the use of real options, given this absence of information? We become more cautious about simple NPV valuations We have a different benchmark by which to look at the shutdown decision

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker25 Real Options in Chapter 11 How long should a bankruptcy judge take to decide whether to shut a firm down? The “Morrison” Conjecture Real options, when sensibly exercised, leave a distinct footprint The shutdown decisions of good bankruptcy judges should follow the same pattern

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker26 The Footprint of a Real Option How long do you stay in a job before looking for something better? At the start, you don’t know enough to stop As you continue, you get more and more information The job is bad and is not getting better The job is great and other jobs are not going to be better

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker27 The Footprint of a Real Option It doesn’t make sense to quit until you have enough information As time goes on, you know more and more After a certain point, you know enough so that if you have not left already, you aren’t going to

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker28 The Footprint of a Real Option We can translate this idea to a graph The number of people who quit their new jobs is low initially It rises as they learn more It then falls as the only people left are those who like the job. The graph is hump-shaped The middle of the “hump” is the average amount of time it takes to learn whether the job is right for you

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker29 The Footprint of a Real Option This pattern—this inverted U-shaped graph—can be observed empirically when real options are sensibly exercised The “Morrison” Conjecture We should find the same pattern in shutdown decisions The “hump” in the graph should peak at 3 months

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker30 Why Three Months? In assessing a firm and its prospects, the bankruptcy judge gathering information in the same way as an auctioneer Auctioneers of firms take about three months to orchestrate a sale The reorganization regime in Sweden uses auctions and they take place in about 3 months on average The Bankruptcy Code itself posits that a plan can be assembled with 120 days

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510 15 The “Morrison” Conjecture Months in Chapter 11 Probability of Shutdown

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker32 Reality Check Survey of Chapter 11 in N.D. Ill. (Eastern Division) Corporations Operating at time of petition Filing in calendar year 1998

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510 15 The “Morrison” Conjecture Months in Chapter 11 Probability of Shutdown

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510 15 The Baird-Morrison-Picker Conjecture Months in Chapter 11 Probability of Shutdown

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Cumulative Shutdowns Months in Chapter 11 Firms Shutdown 100% 5 50% 10 15

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker36 The Real Options Approach to Chapter 11 Standard critiques of Chapter 11 ask how long they take and how many succeed The real options approach says that this is wrong If the shutdown decision is made sensibly, the losers are dismissed quickly at low cost The firms that remain in Chapter 11 after a few months are winners

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker37 The Real Options Approach to Chapter 11 A Chapter 11 regime in which only a few firms emerge intact may be good if shutdown decisions are made well Failures are OK if they are quick The time it takes matters less if chances of success are high

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker38 Firms with Debt Over $1 Million

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker39 Fate of Reorganized Firms

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker40 Do Judges Use Stochastic Calculus? How do bankruptcy judges actually make shutdown decisions? The bankruptcy judge uses different rules of thumb These are all different ways of asking, “Have I seen enough to know that this firm isn’t going to make it?”

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker41 Rules of Thumb 13 O’Clock Rule Cash-Flow Rule Three Strikes (Maybe Two) and You’re Out Meeting Milestones The Company You Keep

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker42 What Firms Reorganize Successfully in Chapter 11? There must be a sound core business. A well-established firm that has experienced a one-time shock is likely to succeed. New businesses and those that can’t meet new competition are not.

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker43 Why couldn’t you reach a deal outside of Chapter 11? A firm with only one large institutional creditor is less likely to succeed. A firm with non-financial judgment creditors and tax collectors is.

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker44 Filings (by firm type)

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker45 Precipitating Event

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker46 Real Options in Action There are many different motions, brought by many different parties that implicate the shutdown decision. But all of them raise the same set of questions

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker47 Real Options in Action Consider a standard scenario The operating statement shows a negative cash flow for your debtor The U.S. Trustee brings a motion to dismiss What is the judge thinking as you start to make your argument?

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Oct. 18, 2001NCBJ: Baird, Morrison & Picker48 Real Options in Action Viable businesses don’t keep losing money If things don’t change, I have to grant this motion (or another one just like it) sooner or later I don’t want to find myself here a month from now doing then what I can do now Unless this guy can tell me what is going to change, I might as well grant the motion now

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