“The payment of debts is necessary for social order. The non-payment is quite equally necessary...

“The payment of debts is necessary for social order. The non-payment is quite equally necessary for social order. For centuries humanity has oscillated, serenely unaware, between these two contradictory necessities.”—Simone Weil

UAL—What’s important How bankruptcy process (Chapter 11) works

– Automatic Stay, DIP financing, Reorg plan

Why we have Chapter 11– Debtor-friendly nation going back to founding

Costs of financial distress are real– In bankruptcy and before bankruptcy

– Rooted in human imperfections» Bounded knowledge

» Self-interested deceit

Trade-off theory of capital structure© Carliss Y. Baldwin, 2010

Priority of claims in Chapter 11

Secured 100% Super-priority (DIP) 100% Priority 100%

– Admin

– Wages, salaries, commissions

– Employee benefits

– Facilities storing grain or fish

– Consumer deposits

– Alimony and child support

– Taxes

– Claims of FDIC-insured institutions

Other unsecured 4-8% Preferred stock 0% Common Stock 0%

UAL settlement

Power of Bankruptcy Code• Automatic stay

– Prevents parties from seizing assets right away– Does not apply to broker-dealers (a critical fact in Lehman

bankruptcy)• Lifeline of DIP financing (super-senior lines of credit)• Funnels disparate groups into one forum

– Unions, aircraft financiers, gov’t agencies like PBGC• Imposes deadlines on key parties

– Benefit of immediacy• Provides framework/support for negotiations

© Carliss Y. Baldwin, 2010

US is a “debtor-friendly” nationRestructuring Laws Vary by Country

France– Court appointed official helps managers generate a reorganization

plan. Creditors have one representative for all classes. U.K.

– Administration - accountant or lawyer runs the firm. Administrative receivership - secured creditors run the firm. Generally, assets liquidated

Japan– Informal rescues more common than formal bankruptcies, but this

may be changing. Sweden

– Court-appointed official auctions the firm.

© Carliss Y. Baldwin, 2010

Optimal/Target capital structure—Checklist Can company pay interest—coverage ratios?

– EBIT/Int, EBITDA/Int– In good times and bad

Industry volatility or cyclicality?– Operating leverage makes cash flow more volatile/cyclical

Industry standards—what are competitors doing? Is company able to make use of its ITS? Costs of financial distress?

– What will customers and suppliers do in shadow of bankruptcy? Agency costs?

– High leverage=>Mgrs take negative NPV projects with high risk– Low leverage=>Mgrs have few incentives to be efficient, may consume

excess perks (private jets, plush offices…) Leverage needed to control renk-seeking?

– Unions and/or regulators Does company need strategic flexibility?

– Will covenants interfere with strategy?© Carliss Y. Baldwin, 2010

Getting to your optimal capital structure From low leverage, it’s easy: do a

leveraged recap From high leverage, it’s hard Assume D+E is approx constant

(Ignore value of ITS) Each 1% decline in D/V =>

$55MM in new equity To go from 78% to 50% requires ~

$1.5 B in new equity! At least 100 MM new shares (1.5

B/$15) Dilution = 100/(100+71) = 58% Family share = 42% of what it was

before the issue

Stone’s V = D+E = 4323 +1189 = 5512

© Carliss Y. Baldwin, 2010

And that’s before announcement effects! Two explanations for the drop in Pstk on announcement of equity

issue Debt overhang

– Transfer of value from new equity to impaired debt

– Arises under symmetric information when D/V is high Signaling

– Action (debt or equity) communicates true state of company to market

– Arises under asymmetric information when D/V is anything Net result => Companies are reluctant to issue equity

– … even when company is over-levered and experiencing costs of financial distress (out of bankruptcy)

– … when a company bucks the trend, it is punished (Wyndham last week)

Converts can be “backdoor equity”

© Carliss Y. Baldwin, 2010