25 1 CHAPTER 25 Bankruptcy Reorganization and Liquidation

25 - 2 What are the major causes of business failure? n. Economic factors l industry weakness l poor location/product n. Financial factors l too much debt l insufficient capital Most failures occur because a number of factors combine to make the business unsustainable. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 3 Do business failures occur evenly over time? n 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. n The failure rate of businesses has tended to fluctuate with the state of the economy. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 4 What size firm, large or small, is more prone to business failure? n Bankruptcy is more frequent among smaller firms. n Large firms tend to get more help from external sources to avoid bankruptcy, given their greater impact on the economy. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 5 What key issues must managers face in the financial distress process? n Is it a temporary problem (technical insolvency) or a permanent problem caused by asset values below debt obligations (insolvency in bankruptcy)? n Who should bear the losses? n Would the firm be more valuable if it continued to operate or if it were (More. . . ) liquidated? Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 6 n Should the firm file for bankruptcy, or should it try to use informal procedures? n Who would control the firm during liquidation or reorganization? Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 7 What informal remedies are available to firms in financial distress? n Informal reorganization n Informal liquidation n Why might informal remedies be preferable to formal bankruptcy? n What types of companies are most suitable for informal remedies? Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 8 Informal Bankruptcy Terminology n Workout: Voluntary informal reorganization plan. n Restructuring: Current debt terms are revised to facilitate the firm’s ability to pay. l 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 © 2005 Harcourt Inc. All rights reserved.

25 - 9 l 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. n 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 © 2005 Harcourt Inc. All rights reserved.

25 - 10 Describe the following terms related to U. S. bankruptcy law: n Chapter 11: Business reorganization guidelines. n Chapter 7: Liquidation procedures. n Trustee: l Appointed to control the company when current management is incompetent or fraud is suspected. l Used only in unusual circumstances. (More. . . ) Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 11 n Voluntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s management. n Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm’s creditors. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 12 What are the major differences between an informal reorganization and reorganization in bankruptcy? n Informal Reorganization: l Less costly l Relatively simple to create l Typically allows creditors to recover more money and sooner. (More. . . ) Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 13 n Reorganization in Bankruptcy l. Avoids holdout problems. l. Due to automatic stay provision, avoids common pool problem. l. Interest and principal payments may be delayed without penalty until reorganization plan is approved. (More. . . ) Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 14 l. Permits the firm to issue debtor in possession (DIP) financing. l. Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved. l. Reduces fraudulent conveyance problem. l. Cramdown if majority in each creditor class approve plan. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 15 What is a prepackaged bankruptcy? n New type of reorganization l Combines the advantages of both formal and informal reorganizations. l Avoids holdout problems l Preserves creditors’ claims l Favorable tax treatment. n Agreement to plan obtained from creditors prior to filing for bankruptcy. n Plan filed with bankruptcy petition. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 16 List the priority of claims in a Chapter 7 liquidation. n Secured creditors. n Trustee’s administrative costs. n Expenses incurred after involuntary case begun but before trustee appointed. n Wages due workers within 3 months prior to filing. (More. . . ) Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 17 n Unpaid contributions to employee benefit plans that should have been paid within 6 months prior to filing. n Unsecured claims for customer deposits. n Taxes due. n Unfunded pension plan liabilities. n General (unsecured) creditors. n Preferred stockholders. n Common stockholders. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 18 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 © 2005 Harcourt Inc. $10. 0 5. 0 0. 3 0. 5 0. 2 3. 0 0. 5 4. 0 $23. 5 (More. . . ) All rights reserved.

25 - 19 Proceeds from liquidation: From current assets $14. 0 From fixed assets* 2. 5 Total receipts $16. 5 * All fixed assets pledged as collateral to mortgage holders. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 20 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. 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 © 2005 Harcourt Inc. All rights reserved.

25 - 21 General Creditor Distribution (millions of $) Remaining Initial Final Percent Creditor GC Claim Distrib. a Amountb Received Accounts payable $10. 0 $6. 500 65. 0% Notes payable 5. 0 3. 250 5. 000 100. 0 Accrued wages 0. 0 0. 300 100. 0 Federal taxes 0. 0 0. 500 100. 0 Other taxes 0. 0 0. 200 a Pro rata amount = $13/$20 = 0. 65. 100. 0 priority distribution and $1. 75 transfer from b Includes Firstsubordinated mortgage debentures. 0. 5 0. 325 2. 825 94. 2 Copyright © 2005 Harcourt Inc. All rights reserved. Second mortgage 0. 5 0. 325

25 - 22 Other Motivations for Bankruptcy n Normally, bankruptcy is motivated by serious current financial problems. n However, some companies have used bankruptcy proceedings for other purposes: l To break union contracts l To hasten liability settlements Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 23 Some Criticisms of Bankruptcy Laws n Critics contend that current (1978) bankruptcy laws are flawed. n Too much value is siphoned off by lawyers, managers, and trustees. n Companies that have no hope remain alive too long, leaving little for creditors when liquidation does occur. n Companies in bankruptcy can hurt other companies in industry. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 24 Chapter 25 Extension n MDA to predict bankruptcy n Recent business

25 - 25 What is MDA, and how can it be used to predict bankruptcy? n Multiple discriminant analysis (MDA) is a statistical technique similar to multiple regression. n It identifies the characteristics of firms that went bankrupt in the past. n Then, data from any firm can be entered into the model to assess the likelihood of future bankruptcy. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 26 MDA Illustration n Assume you have the following 1997 data for 12 companies: l Current ratio l Debt ratio n Six of the companies (marked by Xs) went bankrupt in 1998 while six (marked by dots) remained solvent. (More. . . ) Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 27 Current Ratio Solvent Firms . . . = Solvent X =

25 - 28 n The discriminant boundary, or Z line, statistically separates the bankrupt and solvent companies. n 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 © 2005 Harcourt Inc. All rights reserved.

25 - 29 n Assume the equation for the boundary line is Z = -2 + 1. 5(Current ratio) - 5. 0(Debt ratio). n 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. Copyright © 2005 Harcourt Inc. All rights reserved.

25 - 30 Using MDA To Predict Bankruptcy n 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. n 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 © 2005 Harcourt Inc. All rights reserved.

25 - 31 Some Final Points n The most well-known bankruptcy prediction model is Edward Altman’s five factor model. n Such models tend to work relatively well, but only for the near term. n The more similar the historical sample to the firm being evaluated, the better the prediction. Copyright © 2005 Harcourt Inc. All rights reserved.