Corporate Finance Ross  Westerfield  Jaffe

1. Chapter Thirty One 31 Financial Distress Corporate Finance Ross Westerfield  Jaffe Sixth Edition Prepared by Gady Jacoby University of Manitoba and Sebouh Aintablian American University of Beirut

2. Executive Summary • This chapter discusses financial distress, private workouts, and bankruptcy. • A firm that defaults on a required payment may be forced to liquidate its assets. More often, a defaulting firm will reorganize. • Financial restructuring involves replacing old financial claims with new ones and takes place with private workouts or legal bankruptcy.

3. 31.1 What is Financial Distress? 31.2 What Happens in Financial Distress? 31.3 Bankruptcy Liquidation and Reorganization 31.4 Current Issues in Financial Distress 31.5 The Decision to Seek Court Protection: The Case of Olympia and York 31.6 Summary and Conclusions Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model Chapter Outline

4. 31.1 What is Financial Distress? • A situation where a firm’s operating cash flows are not sufficient to satisfy current obligations and the firm is forced to take corrective action. • Financial distress may lead a firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its equity investors. • Usually the firm is forced to take actions that it would not have taken if it had sufficient cash flow.

5. Solvent firm Insolvent firm Debt Assets Assets Debt Equity Equity Note the negative equity Insolvency • Stock-base insolvency; the value of the firm’s assets is less than the value of the debt. Debt

6. $ Cash flow shortfall Contractual obligations time Insolvency Insolvency • Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments. Firm cash flow

7. Firm Liabilities ($m) Bankruptcy Date Texaco $21,603 1987 Executive Life Insurance 14,577 1991 Mutual Benefit Life 13,500 1991 Campeau 9,947 1990 First Capital Holdings 9,291 1991 Baldwin United 9,000 1983 Continental Airlines (II) 6,200 1990 Lomas Financial 6,127 1989 Macy’s 5,300 1992 The Largest U.S. Bankruptcies

8. 31.2 What Happens in Financial Distress? • Financial distress does not usually result in the firm’s death. • Firms deal with distress by • Selling major assets. • Merging with another firm. • Reducing capital spending and research and development. • Issuing new securities. • Negotiating with banks and other creditors. • Exchanging debt for equity. • Filing for bankruptcy.

9. No financialrestructuring Privateworkout Financialrestructuring Legal bankruptcy What Happens in Financial Distress Financialdistress Financialdistress Reorganize and emerge Liquidation Reorganize and emerge Financialdistress Merge with another firm

10. Responses to Financial Distress • Think of the two sides of the balance sheet. • Asset Restructuring: • Selling major assets. • Merging with another firm. • Reducing capital spending and R&D spending. • Financial Restructuring: • Issuing new securities. • Negotiating with banks and other creditors. • Exchanging debt for equity. • Filing for bankruptcy.

11. 31.3 Bankruptcy Liquidation and Reorganization • Firms that cannot meet their obligations have two choices: liquidation or reorganization. • Liquidation means termination of the firm as a going concern. • It involves selling the assets of the firm for salvage value. • The proceeds, net of transactions costs, are distributed to creditors in order of priority. • Reorganization is the option of keeping the firm a going concern. • Reorganization sometimes involves issuing new securities to replace old ones.

12. Bankruptcy Liquidation Straight liquidation usually involves: • A petition is filed in a federal court. The debtor firm could file a voluntary petition or the creditors could file an involuntary petition against the firm. • A trustee-in-bankruptcy is elected by the creditors to take over the assets of the debtor firm. The trustee will attempt to liquidate the firm’s assets. • After the assets are sold, after payment of the costs of administration, money is distributed to the creditors. • If any money is left over, the shareholders get it.

13. Bankruptcy Liquidation: Priority of Claims The distribution of the proceeds of liquidation occurs according to the following priority: • Administration expenses associated with liquidation. • Other expenses arising after the filing of an involuntary bankruptcy petition. • Wages, salaries and commissions. • Municipal tax claims. • Rent. • Claims resulting from employee injuries. • Unsecured creditors. • Preferred shareholders. • Common shareholders.

14. Example • Suppose the B.O. Drug Co. decides to liquidate. • Assume that the liquidation value is $2.7 million. Bonds worth $1.5 million are secured by a mortgage on the corporate headquarters building, which is sold for $1 million. $200,000 is used to cover administrative costs and other claims—after paying this, $2.5 million is available to pay creditors. The only problem is that the unpaid debt is $4 million.

15. Type of Claim Prior Claim Cash Received Under Liquidation Mortgage Bonds $1,500,000 $1,500,000 Subordinated Debentures $2,500,000 $1,000,000 Common Stock $10,000,000 $ 0 Total $14,000,000 $2,500,000 Example (continued) Following our list of priorities, all creditors are paid before shareholders, and the mortgage bondholders are first in line. The trustee proposes the following distribution:

16. Bankruptcy Reorganization: A typical sequence: • A voluntary petition can be filed by the corporation or an involuntary petition can be filed by creditors. • A federal judge either approves or denies the petition. • In most cases the debtor continues to run the business. • The firm is required to submit a reorganization plan. • Creditors and shareholders are divided into classes. • After acceptance by the creditors, the plan is confirmed by the court. • Payments in cash, property, and securities are made to creditors and shareholders.

17. Assets $3,000,000 Liabilities: Mortgage bonds $1,500,000 Subordinated debentures $2,500,000 Equity -$1,000,000 Reorganization Example • Suppose the B.O. Drug Co. decides to reorganize under the Bankruptcy and Insolvency Act. • Assume that the “going concern” value is $3 million and its balance sheet is shown.

18. Old Security Old Claim New Claim Under Reorganization Mortgage bonds $1,500,000 $1,500,000 Subordinated debentures $2,500,000 $1,000,000 Reorganization Example The firm has proposed the following reorganization plan:

19. Old Security New Claim Under Reorganization Mortgage bonds $1,000,000 in 9% subordinated debentures $500,000 in 11% subordinated debentures Subordinated debentures $1,000,000 in 8% preferred stock $500,000 in common stock Reorganization Example And a distribution of new securities under a new claim with the reorganization plan:

20. 31.4 Current Issues in Financial Distress • Both formal bankruptcy and private workouts involve exchanging new financial claims for old financial claims. • Usually senior debt is replaced with junior debt and debt is replaced with equity. • When they work, private workouts are better than a formal bankruptcy. • Complex capital structures and lack of information make private workouts less likely.

21. Private Workout or Bankruptcy: Which is Best? • In Canada, the new Bankruptcy and Insolvency Act has added increased costs and time commitments to the formal bankruptcy proceedings. • Direct negotiations (private workouts) between creditors and debtors can be expected to increase. • Bankruptcy is better for equity investors than for creditors because equity investors can usually hold out for a better deal in bankruptcy.

22. Prepackaged Bankruptcy • Prepackaged Bankruptcy is a combination of a private workout and legal bankruptcy. • The firm and most of its creditors agree to private reorganization outside the formal bankruptcy. • After the private reorganization is put together (prepackaged) the firm files a formal bankruptcy. • The main benefit is that it forces holdouts to accept a bankruptcy reorganization. • Offers many of the advantages of a formal bankruptcy, but is more efficient.

23. The Decision to Seek Court Protection: The Case of Olympia and York • Olympia and York (O&Y) was one of the largest companies in Canada. • On May 14, 1992, O&Y filed for court protection in Canada under the Companies’ Creditors Arrangement Act. • The recession of the early 1990s led to a major decline in real estate prices and an increase in vacancy rates. • O&Y (a highly leveraged company) could not service its debt because of a lack of cash flow.

24. The Decision to Seek Court Protection: The Case of Olympia and York (continued) • Costs of the O&Y restructuring include: • Direct costs of restructuring. Legal fees $5.75 million Accounting fees 2.65 million Costs of financial advisors 8.50 million • Indirect costs of restructuring: management distraction, loss of customers, and loss of reputation. • Costs of a complicated financial structure: Conflicts between managers, shareholders, and creditors make reaching a private agreement difficult.

25. 31.6 Summary and Conclusions • Financial distress is a situation where a firm’s operating cash flow is not sufficient to cover contractual obligations. • Financial restructuring can be accomplished with a private workout or formal bankruptcy. • Corporate bankruptcy involves liquidation or reorganization. • A hybrid of a private workout and formal bankruptcy is prepackaged bankruptcy.

26. Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model • Many potential lenders use credit scoring models to assess the creditworthiness of prospective borrowers. • The general idea is to find factors that enable the lenders to discriminate between good and bad credit risks. • Edward Altman has developed a model using financial statement ratios and multiple discriminant analyses to predict bankruptcy for publicly traded manufacturing firms

27. Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model (continued) • The resultant model is of the form: Z = 3.3(EBIT/Total assets) + 1.2(Net working capital/Total assets) + 1.0(Sales/Total assets) + 0.6(Market value of equity/Book value of debt) + 1.4(Accumulated retained earnings/Total assets) where Z is an index of bankruptcy. • Bankruptcy would be predicted if Z  1.81 and nonbankruptcy if Z  2.99.

28. Appendix 31-A: Predicting Corporate Bankruptcy: The Z-score model (continued) • Altman uses a revised model to make it applicable for private firms and non-manufacturers. • The resulting model is: Z = 6.56(Net working capital/Total assets) + 3.26(Accumulated retained earnings/Total assets) + 1.05(EBIT/Total assets) + 6.72(Book value of equity/Total liabilities) where Z  1.23 indicates a bankruptcy prediction. 1.23  Z  2.90 indicates a grey area, and Z  2.90 indicates no bankruptcy.