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### Firm Valuations and Real Options

The Shutdown Decision in Chapter 11

The Shutdown Decision in Chapter 11

- A firm enters Chapter 11 as an operating business
- At one or more points, someone asks the judge to pull the plug
- How should the judge approach this question?

NCBJ: Baird, Morrison & Picker

The Shutdown Decision in Chapter 11

- Timing is everything
- Shut down the firm too soon, and a viable business is lost forever
- Wait too long, and you have made a bad situation worse

NCBJ: Baird, Morrison & Picker

The Shutdown Decision in Chapter 11

- Judges must make the right decision at the right time
- The judge is exercising what economists call a “real option”
- This “real options” idea should be incorporated into net present value calculations
- It provides a powerful intuition for analyzing many issues in Chapter 11

NCBJ: Baird, Morrison & Picker

Measuring Present Value

- Casual net present value calculations assume that you have to make an up-or-down decision today
- The ability to wait itself affects the net present value calculations in Chapter 11 and elsewhere

NCBJ: Baird, Morrison & Picker

“and we do well, we are worth $250.”

“and we do poorly, we are worth $80.”

10%

90%

HypoDebtor Firm

Creditors

$100

“If we operate …”

“We can sell the assets for $100.”

NCBJ: Baird, Morrison & Picker

Liquidate

10% x $250 = $25

90% x $80 = $72

Expected Total = $97

Present Value = $97/1.1 = $88

$100

Should We Liquidate the Firm?- “Casual” Net Present Value Calculation
- Assume 10% Interest Rate

NCBJ: Baird, Morrison & Picker

Wrong! Ignores Choices and Benefits of More Info

- Try a Different Approach
- Key Assumption: After operating one period, firm can still be liquidated for $100
- Operating does not reduce liquidation value
- Think of perhaps real estate or intellectual property

NCBJ: Baird, Morrison & Picker

If bad operations, liquidate instead

Operating One Period

Liquidate

Succeeds: 10% x $250 = $25

Fails: 90% x $100 = $90

Expected Total = $115

Present Value = $115/1.1 = $105

$100

Better NPV CalculationNCBJ: Baird, Morrison & Picker

Controlling Timing v. Now-or-Never Decisions

- The Now-or-Never Decision
- Liquidate Now with NPV of $100
- The Value of a One-Period Option to Wait
- $4.54
- By operating the firm for one period, we increase PV by $4.54
- We gain info, and learn whether the firm can succeed

NCBJ: Baird, Morrison & Picker

From The Paper

- “Some firms should be kept intact even though the expected earnings of the firm over time are less than the cash that can be realized from the piecemeal sale of its assets today.”

NCBJ: Baird, Morrison & Picker

Core Idea

- “Sample” operations to try to grab the high end of the distribution and, if not, exit to liquidation
- Sampling requires waiting
- Waiting is costly, even when the assets don’t decline in value
- But uncertainty makes some waiting desirable

NCBJ: Baird, Morrison & Picker

Searching for the Perfect Cup of Coffee

Store B

Store C

Store A

Store D

We know, but X doesn’t know, that the coffee is worth at

A: $10, B: $9, C: $8, D: $7

Price for Coffee: $6

X knows distribution of values

It costs X $1 to visit a store

Return to store for free

NCBJ: Baird, Morrison & Picker

What Should X Do?

- X should go to at least one store
- Worst outcome is find coffee worth $7
- Pay $6 for coffee + $1 for search and break even
- 3 of 4 times find coffee worth 8, 9 or 10 and do better than that

NCBJ: Baird, Morrison & Picker

When Should X Stop?

- X finds A in 1st Search
- Suppose X stumbles on to A in her first search and finds coffee worth $10
- X cannot do better than A
- She should should stop, pay $6, plus $1 search cost, and be $3 to the good

NCBJ: Baird, Morrison & Picker

Suppose X finds B in 1st Search

- X has coffee worth $9 in hand
- X could only do better by finding store A, with coffee worth $10
- She would have to pay $1 to look again, and could gain only $1, and 2/3 of the time she will not find A on her next search
- X should stop if she finds B in her first search

NCBJ: Baird, Morrison & Picker

Suppose X finds C in 1st Search

- X has coffee worth $8 in hand
- X could only do better by finding store A or B, with coffee worth $10 or $9
- The cost of another search is $1
- The expected gain is (1/3) x $2 + (1/3) x $1 + (1/3) x $0 = $1
- She is indifferent between searching and not searching?

NCBJ: Baird, Morrison & Picker

Wrong!

- After we find D on the second search, we know where A and B are and have the option to search again.
- Once we know C and D, the expected gain from searching is (1/2) x 2 + (1/2) x 1 = 1.5
- The cost is 1, so the expected net gain from the search is 0.5
- So our calculation for C is (1/3) x $2 + (1/3) x $1 + (1/3) x $0.50 = 1.16 against a cost of $1, so we should search again if we find C on the first search

NCBJ: Baird, Morrison & Picker

Suppose X find D in 1st Search

- X has coffee worth $7 in hand
- X knows she will do better by going to another store.
- The cost of another search is $1
- The expected gain is (1/3) x $3 + (1/3) x $2 + (1/3) x $??? > $1
- X should should look again if she finds D

NCBJ: Baird, Morrison & Picker

Search Rule So Far

- Undertake first search
- If find A or B, stop
- If find C or D, search again

NCBJ: Baird, Morrison & Picker

The Rest of the Search Rule

- After Finding C or D in First Search, in Second Search
- If X finds A or B, stop.
- If X finds C or D, expected gain from further search is (1/2) x 2 + (1/2) x 1 or 1.5, so search again
- After Finding C or D in Second Search, after Third Search
- Stop

NCBJ: Baird, Morrison & Picker

Tying this to Bankruptcy and Shutdown Decisions

- The bankruptcy judge is presented with a proposed disposition of the assets of the estate
- What is the likely distribution of better proposals?
- What is the cost of considering each proposal?
- When should the judge stop considering proposals?

NCBJ: Baird, Morrison & Picker

Pricing the Option to Wait

- We wait to learn; if we are certain, there is nothing to learn, and no reason to wait
- The more uncertainty—the more volatility—associated with the operations of the firm, the more valuable it is to wait
- The Black-Scholes Option Pricing Formula gives us a formal way to value real options
- But we don’t have the same amount of information that exists for financial options

NCBJ: Baird, Morrison & Picker

Real Options in Chapter 11

- What is the use of real options, given this absence of information?
- We become more cautious about simple NPV valuations
- We have a different benchmark by which to look at the shutdown decision

NCBJ: Baird, Morrison & Picker

Real Options in Chapter 11

- How long should a bankruptcy judge take to decide whether to shut a firm down?
- The “Morrison” Conjecture
- Real options, when sensibly exercised, leave a distinct footprint
- The shutdown decisions of good bankruptcy judges should follow the same pattern

NCBJ: Baird, Morrison & Picker

The Footprint of a Real Option

- How long do you stay in a job before looking for something better?
- At the start, you don’t know enough to stop
- As you continue, you get more and more information
- The job is bad and is not getting better
- The job is great and other jobs are not going to be better

NCBJ: Baird, Morrison & Picker

The Footprint of a Real Option

- It doesn’t make sense to quit until you have enough information
- As time goes on, you know more and more
- After a certain point, you know enough so that if you have not left already, you aren’t going to

NCBJ: Baird, Morrison & Picker

The Footprint of a Real Option

- We can translate this idea to a graph
- The number of people who quit their new jobs is low initially
- It rises as they learn more
- It then falls as the only people left are those who like the job.
- The graph is hump-shaped
- The middle of the “hump” is the average amount of time it takes to learn whether the job is right for you

NCBJ: Baird, Morrison & Picker

The Footprint of a Real Option

- This pattern—this inverted U-shaped graph—can be observed empirically when real options are sensibly exercised
- The “Morrison” Conjecture
- We should find the same pattern in shutdown decisions
- The “hump” in the graph should peak at 3 months

NCBJ: Baird, Morrison & Picker

Why Three Months?

- In assessing a firm and its prospects, the bankruptcy judge gathering information in the same way as an auctioneer
- Auctioneers of firms take about three months to orchestrate a sale
- The reorganization regime in Sweden uses auctions and they take place in about 3 months on average
- The Bankruptcy Code itself posits that a plan can be assembled with 120 days

NCBJ: Baird, Morrison & Picker

Reality Check

- Survey of Chapter 11 in N.D. Ill. (Eastern Division)
- Corporations
- Operating at time of petition
- Filing in calendar year 1998

NCBJ: Baird, Morrison & Picker

The Real Options Approach to Chapter 11

- Standard critiques of Chapter 11 ask how long they take and how many succeed
- The real options approach says that this is wrong
- If the shutdown decision is made sensibly, the losers are dismissed quickly at low cost
- The firms that remain in Chapter 11 after a few months are winners

NCBJ: Baird, Morrison & Picker

The Real Options Approach to Chapter 11

- A Chapter 11 regime in which only a few firms emerge intact may be good if shutdown decisions are made well
- Failures are OK if they are quick
- The time it takes matters less if chances of success are high

NCBJ: Baird, Morrison & Picker

Firms with Debt Over $1 Million

NCBJ: Baird, Morrison & Picker

Fate of Reorganized Firms

NCBJ: Baird, Morrison & Picker

Do Judges Use Stochastic Calculus?

- How do bankruptcy judges actually make shutdown decisions?
- The bankruptcy judge uses different rules of thumb
- These are all different ways of asking, “Have I seen enough to know that this firm isn’t going to make it?”

NCBJ: Baird, Morrison & Picker

Rules of Thumb

- 13 O’Clock Rule
- Cash-Flow Rule
- Three Strikes (Maybe Two) and You’re Out
- Meeting Milestones
- The Company You Keep

NCBJ: Baird, Morrison & Picker

What Firms Reorganize Successfully in Chapter 11?

- There must be a sound core business.
- A well-established firm that has experienced a one-time shock is likely to succeed.
- New businesses and those that can’t meet new competition are not.

NCBJ: Baird, Morrison & Picker

Why couldn’t you reach a deal outside of Chapter 11?

- A firm with only one large institutional creditor is less likely to succeed.
- A firm with non-financial judgment creditors and tax collectors is.

NCBJ: Baird, Morrison & Picker

Filings (by firm type)

NCBJ: Baird, Morrison & Picker

Precipitating Event

NCBJ: Baird, Morrison & Picker

Real Options in Action

- There are many different motions, brought by many different parties that implicate the shutdown decision.
- But all of them raise the same set of questions

NCBJ: Baird, Morrison & Picker

Real Options in Action

- Consider a standard scenario
- The operating statement shows a negative cash flow for your debtor
- The U.S. Trustee brings a motion to dismiss
- What is the judge thinking as you start to make your argument?

NCBJ: Baird, Morrison & Picker

Real Options in Action

- Viable businesses don’t keep losing money
- If things don’t change, I have to grant this motion (or another one just like it) sooner or later
- I don’t want to find myself here a month from now doing then what I can do now
- Unless this guy can tell me what is going to change, I might as well grant the motion now

NCBJ: Baird, Morrison & Picker

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