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“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