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Bankruptcy and Financial Distress

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Bankruptcy and Financial Distress. Professor XXXXX Course Name / Number. Economic failure. Return earned by the company is lower than its cost of capital. Firm is unable to pay its liabilities as they come due. - PowerPoint PPT Presentation

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Page 1: Bankruptcy and Financial Distress

Bankruptcy and Financial Distress

Professor XXXXXCourse Name / Number

Page 2: Bankruptcy and Financial Distress

2

Types of Business Failure

Economic failure

Return earned by the company is lower than its cost of capital.

Technical insolvenc

y

Firm is unable to pay its liabilities as they come due.

Company assets are still greater than its liabilities, but company is confronted with a

liquidity crisis.

Insolvency

bankruptcy

Firm's liabilities exceed the market value of its assets.

Courts treat technical insolvency and bankruptcy in the same way.

Page 3: Bankruptcy and Financial Distress

3

Major Causes of Business Failure

Financial distress: the primary cause of business failure

– Over-expansion, poor financial actions, ineffective sales force, and high production costs

Economic activity, especially economic downturns

– Sales may decrease, leaving the firm with high fixed costs and insufficient revenues to cover them.

– Rapid rises in interest rates prior to a recession can further cause cash flow problems.

Corporate maturity: failure to promote R&D or mergers

Page 4: Bankruptcy and Financial Distress

4

Largest Bankruptcies in U.S. History as of December 2, 2001

Company Bankruptcy DateTotal Assets,

PrebankruptcyEnron Corp. December 2, 2001 $63,392,000,000Texaco, Inc. April 12, 1987 35,892,000,000Financial Corp. of America

September 9, 1988

33,864,000,000

Pacific Gas and Electric Co.

April 6, 2001 21,470,000,000

MCorp March 31, 1989 20,228,000,000First Executive Corp. May 13, 1991 15,193,000,000Gibraltar Financial Corp. February 8, 1990 15,011,000,000FINOVA Group, Inc. March 7, 2001 14,050,000,000HomeFed Corp. October 22, 1992 13,885,000,000Southeast Banking Corporation

September 20, 1991

13,390,000,000

Reliance Group Holdings, Inc.

June 12, 2001 12,598,000,000

Imperial Corp. of America February 28, 1990 12,263,000,000Federal-Mogul Corp. October 1, 2001 10,150,000,000Source: http://www.bankuptcydata.com (January 3, 2002)

Page 5: Bankruptcy and Financial Distress

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Voluntary Reorganization

Extension Firm’s creditors receive payment in full, although not immediately.

Composition

Pro rata cash settlement of creditor claims

Creditor control

Committee of creditors decides that operating management be replaced.

Firm may arrange with its creditors a voluntary settlement:

Page 6: Bankruptcy and Financial Distress

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Voluntary Liquidation

Credit committee could recommend liquidation of the firm:

Liquidation: privately or through the legal procedures provided by bankruptcy law

ObjectiveRecover as much per dollar owed as

possible

Alternative to liquidation - the firm is acquired

Page 7: Bankruptcy and Financial Distress

7

Bankruptcy Law in U.S.

Bankruptcy Reform Act of 1978: contains eight odd-numbered (1 through 15) chapters and chapter

12.

Chapter 7 contains procedures to be followed when liquidating a failed firm.

Chapter 11 outlines the procedures for reorganizing a firm:

– Collective legal procedure is begun by which all claims are resolved.

– Individual creditors are prevented from beginning lawsuits against the debtor.

– Eliminates the benefit of being the first to sue because all claims against the firm are settled simultaneously.

Page 8: Bankruptcy and Financial Distress

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Reorganization

Approval

Filing

Appointment

Acceptance of plan

Payment of expenses

Five steps

Allow businesses in temporary financial distress to continue operating:

Disadvantage: managers can file for chapter 11 and choose the bankruptcy procedure that is best for themselves.

Page 9: Bankruptcy and Financial Distress

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Filing

Reorganization petition must be filed in a federal bankruptcy court by the firm or an

outside party.,

Outside party can file for reorganization if:

firm has past-due debts of $5,000 or more,

three or more creditors with aggregate unpaid claims of $5,000 or more, or

the firm is insolvent.

Page 10: Bankruptcy and Financial Distress

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Appointment

DIP is responsible for the valuation of the firm.

The filing firm becomes the debtor in possession (DIP) of the assets:

Creditor committee appointed to represent the interest of creditors.

– If DIP evaluates the value as a going concern of the firm lower than liquidation value, recommend liquidation.

– Otherwise, DIP recommends reorganization.

Page 11: Bankruptcy and Financial Distress

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Reorganization Plan

DIP submits a reorganization plan to the court:

Recapitalization

Key part of reorganization plan

Debt is exchanged for equity or its maturity is extended.

Claims on the new securities issued are distributed based on the seniority of the

existing claims.

Page 12: Bankruptcy and Financial Distress

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Acceptance of the Reorganization Plan

Court approved plan is submitted for approval to the firm’s creditors and

shareholders.

Under unanimous consent procedure (UCP), creditors and equity classes must agree with the

reorganization plan.

When a reorganization plan fails to meet approval by all classes under the UCP, use cramdown

procedure.

The bankruptcy court can approve the plan without the consent of the other classes in cramdown. What is the

procedure?

Page 13: Bankruptcy and Financial Distress

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Acceptance of the Reorganization Plan

– One class of creditors has to vote for reorganization plan in this case.

– Secured creditors retain their prebankruptcy liens on assets.

What if no reorganization plan is adopted under either the UCP or cramdown?

– Managers sometimes voluntarily sell the firm as a going concern.

– The proceeds of the sale are paid to creditors.

– Creditors could petition for the shift of bankruptcy filing to Chapter 7 liquidation.

Page 14: Bankruptcy and Financial Distress

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Payment of Expenses and Capital Structure Restructuring

• After the reorganization plan has been approved or disapproved– A statement of expenses is filed; if approved, the debtor must

pay the expenses within a reasonable period

An example....

Current capital structure for Campbell Technologies

Debentures (unsecured debt) $22,000,000

Subordinated debentures $28,000,000

Common stock (100,000 shares) $20,000,000

Total $70,000,000

Debt/Equity of the company is 2.5 ($50 million/$20 million)

Campbell Technologies is worth $45 million as a going concern

Page 15: Bankruptcy and Financial Distress

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Capital Structure Restructuring

• The company could be reorganized as follows

Debentures (unsecured debt) $11,000,000Subordinated debentures $14,000,000Common stock (200,000 shares) $20,000,000

Total $45,000,000

Debt holders receive 100,000 shares in exchange for cutting their debt claims in half

Debt/Equity ratio is reduced to 1.25 ($25 million/$20 million)

The financial condition of the company is improved by reducing the debt!

Page 16: Bankruptcy and Financial Distress

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Liquidation in Bankruptcy

Final accounting

Procedures

Priority of claims

Three important aspects

Chapter 7 of Code addresses the order of priority of claims:

1. The expenses of administering the bankruptcy

2. Any unpaid interim expenses incurred in the ordinary course of business between filing the bankruptcy petition and the entry of an Order of Relief in an involuntary proceeding

3. Wages of not more than $2,000 per worker that have been earned by workers in the 90-day period immediately preceding the bankruptcy

Page 17: Bankruptcy and Financial Distress

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Liquidation in Bankruptcy

– 4. Unpaid employee benefit plan contributions– 5. Unsecured customer deposits, not to exceed

$900, resulting from purchasing or leasing a good or service from the failed firm

– 6. Taxes owed by the bankrupt firm– 7. Claims of secured creditors, who receive the

proceeds from the sale of collateral held, regardless of the proceeding priorities

– 8. Claims of unsecured creditors– 9. Preferred stockholders, who receive an

amount up to the par value of their preferred stock

– 10. Common stockholders, who receive any remaining funds, which are distributed on an equal per share basis

Page 18: Bankruptcy and Financial Distress

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Example: Liquidation of Oxford Company

Oxford Company Balance Sheet

Assets Liabilities and Stockholders’ Equity

Cash $3,000,000 Accounts payable $5,000,000

Accounts receivable

10,800,000 Notes payable - bank 23,000,000

Inventories 45,000,000 Accrued wages 2,800,000

Current assets $58,800,000 Unpaid employee benefits 3,100,000

Net plant $27,200,000 Unsecured customer deposits

4,000,000

Net equipment 20,000,000 Taxes payable 10,000,000

Net fixed assets $47,200,000 Total current liabilities $47,900,000

Total $106,000,000

First mortgage $12,000,000

Page 19: Bankruptcy and Financial Distress

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Balance Sheet of Oxford Company

Oxford Company Balance Sheet

Assets Liabilities and Stockholders’ Equity

Second mortgage $8,000,000

Subordinated debentures 10,000,000

Total long-term debt $30,000,000

Preferred stock (100,000 shares)

$7,000,000

Common stock (1 million shares)

$14,000,000

Paid-in capital in excess of par

$3,000,000

Retained earnings $4,100,000

Total common stockholders’ equity

$28,100,000

Total $106,000,000

Page 20: Bankruptcy and Financial Distress

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Distribution of Liquidation Proceeds• Oxford Company is liquidating its assets under Chapter 7:

– The trustees obtained $25 million for the firm’s current assets and $22 million for the firm’s fixed assets.

– Oxford has extra liability of $1,000,000 in expenses for administering the bankruptcy proceedings.

Proceeds from Liquidation $47,000,000

Expenses of administering bankruptcy and paying bills

$1,000,000

Wages owed workers 2,800,000

Unpaid employee benefits 3,100,000

Unsecured customer deposits 4,000,000

Taxes owed government 10,000,000

Funds available for creditors $26,100,000

First mortgage, paid from $22 mil proceeds of fixed asset sales

12,000,000

Second mortgage, partially paid from the remaining assets

4,000,000

Funds available for unsecured creditors 10,100,000

Page 21: Bankruptcy and Financial Distress

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Predicting Bankruptcy

Z = 1.2 x X1 + 1.4 x X2 + 3.3 x X3 + 0.6 x X4 + 1.0 x X5

Where X1 = working capital / total assets

X2 = retained earnings / total assets

X3 = earnings before interest and taxes / total assets

X4 = market value of equity / book value of debt

X5 = sales / total assets

Altman’s Z score: quantitative model that uses a blend of traditional financial ratios and multiple

discriminant analysis:About 90% accurate in forecasting bankruptcy one year in the

futureAbout 80% accurate in forecasting bankruptcy two years in the

future

Page 22: Bankruptcy and Financial Distress

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Poff Industries Balance Sheet

Poff Industries Balance Sheet

Assets Liabilities and Stockholders’ Equity

Cash $800,000 Accounts payable $8,000,000

A/R 12,000,000 Notes payable - bank 4,900,000

Inventories 25,000,000 Total current liabilities $12,900,000

Current assets $37,800,000 Mortgage $10,000,000

Land $9,000,000 Debentures 16,000,000

Net plant 10,000,000 Total long-term debt $26,000,000

Net equipment 14,000,000 Preferred stock (100,000 shares) $5,000,000

Fixed assets $33,000,000 Common stock (1 million shares) 11,000,000

Total $70,800,000 Paid-in capital in excess of par 10,000,000

Retained earnings 5,900,000

Total stockholders’ equity $31,900,000

Total $70,800,000

Page 23: Bankruptcy and Financial Distress

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Income Statement of Poff Industries

Poff Industries Income Statement

Sales $62,000,000

Cost of goods sold 38,000,000

Selling and administrative $12,000,000

Earnings before interest and taxes

$12,000,000

Interest 2,000,000

Earnings before taxes $10,000,000

Taxes (40%) 6,000,000

Net income $4,000,000

Page 24: Bankruptcy and Financial Distress

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Z score for Poff Industries

• Company’s stock price currently is $39 per share:

Z = 1.2 x (0.35) + 1.4 x (0.083) + 3.3 x (0.17) + 0.6 x (1.5) + 1.0 x (0.88) = 2.88.

• Using Z score, businesses are classified in:– Companies with high probability of failure, Z is

less than 1.8.– Companies with unsure probability of failure, Z is

between 1.81 and 2.99.– Companies with low probability of failure, Z is

higher than 3.• Poff Industries has Z score of 2.88

– It is uncertain whether Poff Industries will fail or not based on the Z score.

Page 25: Bankruptcy and Financial Distress

A firm can fail if is technically insolvent or insolvent.

Mismanagement is the primary cause of business failure.

Companies in financial distress can reorganize or liquidate.

Bankruptcy Reform Act of 1978 specifies in Chapters 7 and 11, respectively, how firms

are liquidated/reorganized.

Bankruptcy and Financial Distress