© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Chapter 25: Bankruptcy and Financial Distress Corporate Finance, 3e Graham, Smart, and Megginson

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy and Business Failure 2 A firm is insolvent whenever its liabilities exceed its assets. Financial distress occurs when a company’s cash flows are insufficient to pay its current obligations. The term bankruptcy does not actually describe a financial condition, but instead refers to a legal process.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy Law in the U.S.  Collective legal procedure is begun by which all claims are resolved.  An automatic stay prevents individual creditors from beginning lawsuits against the debtor.  Debtor-in-possession (DIP)  Eliminates the benefit of being the first to sue because all claims against the firm are settled simultaneously. 3 Bankruptcy Reform Act of 1978: contains eight odd- numbered (1 through 15) chapters and chapter 12. Chapter 7 contains procedures to be followed when liquidating a failed firm. Chapter 11 outlines the procedures for reorganizing a firm:

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Illiquidity 4 In the early stages, a firm filing for chapter 11 frequently faces problems with liquidity.  Cash is depleted.  Lenders may threaten a declaration of default or covenant violations.  Firm faces the loss of revolving credit lines.  Suppliers may demand to be paid in cash up front. The Bankruptcy Code authorizes the company to offer an array of “sweeteners” to lenders who are willing to lend. Under certain conditions, the firm may offer super-priority to new lenders: the right to be paid ahead of everyone else.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Appointment  If DIP evaluates the value as a going concern of the firm lower than liquidation value, recommend liquidation.  Otherwise, DIP recommends reorganization. 5 DIP is responsible for the valuation of the firm. The filing firm becomes the debtor in possession (DIP) of the assets: Creditor committee appointed to represent the interest of creditors.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Reorganization Plan 6 DIP submits a reorganization plan to the court: Recapitalization Key part of reorganization plan Debt is exchanged for equity or its maturity is extended. Claims on the new securities issued are distributed based on the seniority of the existing claims.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 7 Court approved plan is submitted for approval to the firm’s creditors and shareholders. Creditors and equity classes must agree with the reorganization plan. If creditors reject the plan, the debtor may seek a cramdown, where a judge forces creditors to accept the terms of the plan. Acceptance of the Reorganization Plan Absolute priority rule states that stockholders and low- priority creditors can retain no interest in the reorganized company unless all higher-priority creditors are paid in full.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Sources of Aid to Firms that Reorganize  Six major sources of aid come either from the government or from creditors.  They give firms in reorganization advantages relative to firms that continue operating outside of bankruptcy and firms that liquidate. 8

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Bankruptcy Act of 2005  Intended to prevent individuals and firms from shirking their obligations too easily by filing for bankruptcy  Key features of the 2005 Act  Limits the time incumbent management can remain in control of the firm in chapter 11  Limits bonuses that can be paid to retain key employees while in chapter 11  Overall, the chapter 11 process is now more friendly to creditors. 9

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Alternatives to Chapter 11  Out-of-Court Workouts  Prepackaged Bankruptcies  Chapter 7 10

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Prepackaged Bankruptcies  Companies can prepare a reorganization plan that is negotiated and voted on by creditors and stockholders before the company actually files for chapter 11 bankruptcy.  Shortens and simplifies the process and saves money. 11

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. 12 Final accounting Procedures Priority of claims Three important aspects Chapter 7: Liquidation in Bankruptcy Chapter 7 of the Code addresses the order of priority of claims.

© 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Predicting Bankruptcy Z = 1.2(X 1 ) + 1.4(X 2 ) + 3.3(X 3 ) + 0.6(X 4 ) + 1.0(X 5 ) Where X 1 = Working capital / Total assets X 2 = Retained earnings / Total assets X 3 = Earnings before interest and taxes / Total assets X 4 = Market value of equity / Book value of debt X 5 = Sales / Total assets 13 Altman’s Z score: Quantitative model that uses a blend of traditional financial ratios and multiple discriminant analysis: About 90% accurate in forecasting bankruptcy one year in the future About 80% accurate in forecasting bankruptcy two years in the future