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“The payment of debts is necessary for social order. The non-payment is quite equally necessary for social order. For centuries humanity has oscillated, serenely unaware, between these two contradictory necessities.”—Simone Weil
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UAL—What’s important How bankruptcy process (Chapter 11) works –Automatic Stay, DIP financing, Reorg plan Why we have Chapter 11 –Debtor-friendly nation going back to founding Costs of financial distress are real –In bankruptcy and before bankruptcy –Rooted in human imperfections »Bounded knowledge »Self-interested deceit Trade-off theory of capital structure © Carliss Y. Baldwin, 2010
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Priority of claims in Chapter 11 Secured100% Super-priority (DIP)100% Priority100% –Admin –Wages, salaries, commissions –Employee benefits –Facilities storing grain or fish –Consumer deposits –Alimony and child support –Taxes –Claims of FDIC-insured institutions Other unsecured4-8% Preferred stock0% Common Stock0% UAL settlement
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Power of Bankruptcy Code Automatic stay –Prevents parties from seizing assets right away –Does not apply to broker-dealers (a critical fact in Lehman bankruptcy) Lifeline of DIP financing (super-senior lines of credit) Funnels disparate groups into one forum –Unions, aircraft financiers, gov’t agencies like PBGC Imposes deadlines on key parties –Benefit of immediacy Provides framework/support for negotiations © Carliss Y. Baldwin, 2010
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US is a “debtor-friendly” nation Restructuring Laws Vary by Country France –Court appointed official helps managers generate a reorganization plan. Creditors have one representative for all classes. U.K. –Administration - accountant or lawyer runs the firm. Administrative receivership - secured creditors run the firm. Generally, assets liquidated Japan –Informal rescues more common than formal bankruptcies, but this may be changing. Sweden –Court-appointed official auctions the firm.
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© Carliss Y. Baldwin, 2010
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Optimal/Target capital structure—Checklist Can company pay interest—coverage ratios? –EBIT/Int, EBITDA/Int –In good times and bad Industry volatility or cyclicality? –Operating leverage makes cash flow more volatile/cyclical Industry standards—what are competitors doing? Is company able to make use of its ITS? Costs of financial distress? –What will customers and suppliers do in shadow of bankruptcy? Agency costs? –High leverage=>Mgrs take negative NPV projects with high risk –Low leverage=>Mgrs have few incentives to be efficient, may consume excess perks (private jets, plush offices…) Leverage needed to control renk-seeking? –Unions and/or regulators Does company need strategic flexibility? –Will covenants interfere with strategy? © Carliss Y. Baldwin, 2010
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Getting to your optimal capital structure From low leverage, it’s easy: do a leveraged recap From high leverage, it’s hard Assume D+E is approx constant (Ignore value of ITS) Each 1% decline in D/V => $55MM in new equity To go from 78% to 50% requires ~ $1.5 B in new equity! At least 100 MM new shares (1.5 B/$15) Dilution = 100/(100+71) = 58% Family share = 42% of what it was before the issue Stone’s V = D+E = 4323 +1189 = 5512 © Carliss Y. Baldwin, 2010
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And that’s before announcement effects! Two explanations for the drop in Pstk on announcement of equity issue Debt overhang –Transfer of value from new equity to impaired debt –Arises under symmetric information when D/V is high Signaling –Action (debt or equity) communicates true state of company to market –Arises under asymmetric information when D/V is anything Net result => Companies are reluctant to issue equity –… even when company is over-levered and experiencing costs of financial distress (out of bankruptcy) –… when a company bucks the trend, it is punished (Wyndham last week) Converts can be “backdoor equity” © Carliss Y. Baldwin, 2010
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