ronald f singer fina 4330 financial distress lecture 28 l.
Download
Skip this Video
Loading SlideShow in 5 Seconds..
Ronald F. Singer FINA 4330 Financial Distress Lecture 28 PowerPoint Presentation
Download Presentation
Ronald F. Singer FINA 4330 Financial Distress Lecture 28

Loading in 2 Seconds...

play fullscreen
1 / 19

Ronald F. Singer FINA 4330 Financial Distress Lecture 28 - PowerPoint PPT Presentation


  • 182 Views
  • Uploaded on

Ronald F. Singer FINA 4330 Financial Distress Lecture 28. Key Concepts and Skills. Be able to define financial distress and understand what happens to a firm in distress Understand the difference between liquidation and reorganization Understand the absolute priority rule

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Ronald F. Singer FINA 4330 Financial Distress Lecture 28' - yates


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
ronald f singer fina 4330 financial distress lecture 28
Ronald F. Singer

FINA 4330

Financial Distress

Lecture 28

key concepts and skills
Key Concepts and Skills
  • Be able to define financial distress and understand what happens to a firm in distress
  • Understand the difference between liquidation and reorganization
  • Understand the absolute priority rule
  • Understand the potential benefits of a private workout versus formal bankruptcy
outline
Outline

1 What Is Financial Distress?

2 What Happens in Financial Distress?

3 Bankruptcy Liquidation and Reorganization

4 Private Workout or Bankruptcy: Which is Best?

5 Prepackaged Bankruptcy

1 what is financial distress
1 What Is Financial Distress?
  • Financial distress is 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.
insolvency

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

insolvency6

$

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

2 what happens in financial distress
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.
what happens in financial distress

No financialrestructuring

49%

Privateworkout

47%

51%

Financialrestructuring

Reorganize and emerge

83%

53%

Merge withanother firm

Legal bankruptcyChapter 11

7%

10%

Liquidation

What Happens in Financial Distress?

Financialdistress

Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An EmpiricalStudy of Private Reorganization in Firms in Defaults,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss,“Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).

responses to financial distress
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
3 bankruptcy liquidation and reorganization
3 Bankruptcy Liquidation and Reorganization
  • Firms that cannot meet their obligations have two choices: liquidation or reorganization.
  • Liquidation (Chapter 7) 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 (Chapter 11) is the option of keeping the firm a going concern.
    • Reorganization sometimes involves issuing new securities to replace old ones.
bankruptcy liquidation
Bankruptcy Liquidation

Straight liquidation under Chapter 7:

  • 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.
bankruptcy liquidation priority of claims
Bankruptcy Liquidation: Priority of Claims

Liquidation proceeds are distributed in order of priority:

  • Administration expenses associated with liquidation
  • Unsecured claims arising after the filing of an involuntary bankruptcy petition
  • Wages earned within 90 days before the filing date, not to exceed $2,000 per claimant
  • Contributions to employee benefit plans arising with 180 days before the filing date
  • Consumer claims, not exceeding $900
  • Tax claims
  • Secured and unsecured creditors’ claims
  • Preferred stockholders’ claims
  • Common stockholders’ claims
absolute priority rule in practice
Absolute Priority Rule in Practice

The APR states that senior claims are fully satisfied before junior claims receive anything.

Deviations from APR

Equityholders

Expectation: No payout

Reality: Payout in 81% of cases

Unsecured creditors

Expectation: Full payout after secured creditors

Reality: Violation in 78% of cases

Secured creditors

Expectation: Full payout

Reality: Full payout in 92% of cases

reasons for absolute priority rule violations
Reasons for Absolute Priority Rule Violations
  • Creditors want to avoid the expense of litigation. Debtors are given a 120-day window of opportunity to cause delay and harm value.
  • Managers often own equity and demand to be compensated. They are in charge for at least the next 120 days.
  • Bankruptcy judges like consensual plans (they do not clog the court calendar with appeals) and pressure parties to compromise.
bankruptcy reorganization chapter 11
Bankruptcy Reorganization:Chapter 11

A typical sequence:

  • A voluntary petition or an involuntary petition is filed.
  • A federal judge either approves or denies the petition.
  • In most cases the debtor continues to run the business.
  • The firm is given 120 days to submit a reorganization plan.
  • Creditors and shareholders are divided into classes. Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt.
  • After acceptance by the creditors, the plan is confirmed by the court.
  • Payments in cash, property, and securities are made to creditors and shareholders.
4 private workout or bankruptcy which is best
4 Private Workout or Bankruptcy: Which Is Best?
  • 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.
private workout or bankruptcy which is best
Private Workout or Bankruptcy: Which Is Best?
  • Advantages of Bankruptcy
      • New credit is available - "debtor in possession" debt
      • Discontinued accrual of interest on pre-bankruptcy unsecured debt
      • An automatic stay provision
      • Tax advantages
      • Requires only approval by 1/2 of creditors owning 2/3 of outstanding debt
  • Disadvantages of Bankruptcy
      • A long and expensive process
      • Judges are required to approve major business decisions
      • Distraction to management
      • “Hold out” by stockholders
5 prepackaged bankruptcy
5 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 (under Chapter 11).
  • 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.