“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

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

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

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

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.

© Carliss Y. Baldwin, 2010

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

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 = = 5512 © Carliss Y. Baldwin, 2010

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