Distress Valuation Prof Ian Giddy New York University

Distress Valuation Prof. Ian Giddy New York University

What’s Marvel worth? Who’s winning? Who’s losing?

When Default Threatens, Value the Company Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 3

Example of Valuation: Zombie, Inc. Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 4

Valuation in Distress Restructuring Liquidation value l Acquisition price l Enterprise value l Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 6

Enterprise Valuation in Distress Restructuring Multiples l FCFF discounted at WACC l APV l Capital Cash Flows l Option Value l Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 7

Multiples in Distress Do these make sense? Source: morningstar. com Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 8

Free Cash Flows to the Firm @ WACC Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits after tax Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Discount to present using weighted average cost of capital (WACC) Present value of free cash flows Copyright © 2002 Ian H. Giddy + cash, securities & excess assets - Market value of debt … Terminal year FCFF Stable growth model or P/E comparable Value of shareholders equity Corporate Financial Restructuring 9

Free Cash Flows to the Firm @ WACC Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 10

Capital Cash Flow Method l l Use NPV approach Project cash flows based on: u Net income: (R-C-D-I)*(1 -t) u + Loss tax shield: NOL*t u +Cash Flow Adjustments: D-CE- WC+Asset sales u +I l l Find terminal value based on CF(1+g)/(r-g) Discount at unlevered WACC, ie cost of equity with Beta: u Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 11

Capital Cash Flow Method Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 12

Option Value For some, The riskier the better! Mean Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 13

Common Stock as a Call Option l l l The equity in a firm is a residual claim, i. e. , equity holders lay claim to all cashflows left over after other financial claim-holders (debt, preferred stock etc. ) have been satisfied. If a firm is liquidated, the same principle applies, with equity investors receiving whatever is left over in the firm after all outstanding debts and other financial claims are paid off. The principle of limited liability, however, protects equity investors in publicly traded firms if the value of the firm is less than the value of the outstanding debt, and they cannot lose more than their investment in the firm. Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 14

Payoffs to Shareholders on Liquidation Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 15

Option Pricing Model 1. 8 1. 6 CALL OPTION PRICE 1. 4 1. 2 1 0. 8 0. 6 0. 4 0. 2 0 Copyright © 2002 Ian H. Giddy 93 93 94 94 95 FUTURES PRICE 95 96 96 Corporate Financial Restructuring 16

Black-Scholes Option Valuation Co = So. N(d 1) - Xe-r. TN(d 2) d 1 = [ln(So/X) + (r + 2/2)T] / ( T 1/2) d 2 = d 1 - ( T 1/2) where Co = Current call option value. So = Current stock price N(d) = probability that a random draw from a normal dist. will be less than d. Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 17

Marvel’s Option Value, Nov. 96 Option Value When Marvel’s stock price is below $9. 18, Perelman’s investment in the Holding Companies is worthless on a liquidation basis, but still has option value. Breakeven stock price =Debt value/No. of collateral shares n Debt value=Mkt price*face value (Ex 6) n Collateral shares=77. 3 m =$709. 5/77. 3 =$9. 18 Breakeven stock price Nov 96 stock price Copyright © 2002 Ian H. Giddy $4. 63 $9. 18 Marvel Ent. Price Corporate Financial Restructuring 18

The Conflict Between Bondholders and Stockholders l Stockholders and bondholders have different objective functions, and this can lead to conflicts between the two. u l For instance, stockholders have an incentive to take riskier projects than bondholders do, and to pay more out in dividends than bondholders would like them to. Since equity is a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity. u It is therefore conceivable that stockholders can take risky projects with negative net present values, which while making them better off, may make the bondholders and the firm less valuable. Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 19

Vulture Investors l l These funds typically buy large blocks of debt (often across different seniority classes) in distressed firms in order to gain a seat at the bargaining table. As the term “vulture” implies, these investors have been viewed as “bondmailers” who seek only to delay and disrupt reorganizations in order to extract concessions from debtors. But by consolidating large blocks of debt, vulture investors facilitate restructurings by reducing the number of claimholders and aligning incentives across seniority classes. 3 largest players: Trust Company of the West, Fidelity Management and Research, and Apollo Investors. Example: Trust Company of the West played a crucial role in facilitating the prepackaged bankruptcy of Kinder-Care Learning Centers by buying up most of that firm’s bank debt and subordinated debentures. Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 20

Marvel l l 1. Why did Marvel file for Chapter 11? Were the problems caused by bad luck, bad strategy, or bad execution? 2. Evaluate the proposed restructuring plan. Will it solve the problems that caused Marvel to file for Chapter 11? As Carl Icahn, the largest unsecured debtholder, would you vote for the proposed restructuring plan? Why or why not? 3. How much is Marvel's equity worth per share under the proposed restructuring plan, assuming it acquires Toy Biz as planned? What is your assessment of the pro forma financial projections and liquidation assumptions? 4. Will there be a "contagion effect, " making it difficult for Marvel or other companies in the Perelman group to issue debt in the future? Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 22

Source of Problem? Bad luck? l Bad strategy? “Diversified youth entertainment company” l Bad execution? l u. Overpaying for acquisitions u. COGS 50% 65%, SG&A 19 28% l Bad finance? Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 23

Bad Finance? Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 24

Marvel Structure Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 25

Perelman Proposal Buy 427 m new shares for $365 m @ $0. 85 l Pay Marvel creditors in full l Acquire 100% of Toy Biz to use NOLs l Bondholders get 15% of shares (77. 3 m) l Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 26

Marvel Banks n n n Choices: n. Accept Perelman’s plan n. Sell the debt at $. 14 -$. 17 n. Reject plan and propose own n Controls Marvel equity NPV is negative Option value may be positive Icahn et al. Perelman n n Copyright © 2002 Ian H. Giddy Secured and senior Get fully repaid under plan Corporate Financial Restructuring 27

Perelman’s Strategy Has control for 120 days (under Ch 11) l Holds an out-of-the-money call option l He can credibly destroy bond debt value l Hence can extract rents from bondlholders l Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 28

Decision Time l l Evaluate the proposed restructuring plan. Will it solve the problems that caused Marvel to file for Chapter 11? What is the company worth? As Carl Icahn, the largest unsecured debtholder, would you vote for the proposed restructuring plan? Why or why not? What other options does Perelman have? Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 29

Decision Time Perelman Shareholder Group Copyright © 2002 Ian H. Giddy Icahn Bondholder Group Corporate Financial Restructuring 30

What Happened l l l Feb 26 – judge lets bondholders seize their collateral Perelman withdraws his plan Icahn & bondholders propose own plan to change management, Divest Sky Box and Panini & forgive $385 debt Issue rights offering for working capital, pay off DIP, pay most of bank debt Increased value of shares, est. $0. 85 to est $2+ Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 31

Marvel Stock Price Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 32

Marvel Zero-Coupon Bond Price Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 33

Update Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 34

Contact Info Ian H. Giddy NYU Stern School of Business Tel 212 -998 -0426; Fax 212 -995 -4233 Ian. giddy@nyu. edu http: //giddy. org Copyright © 2002 Ian H. Giddy Corporate Financial Restructuring 38