Bankruptcy and Financial Distress Professor XXXXX Course Name / Number

2 Types of Business Failure Economic failure Return earned by the company is lower than its cost of capital. Technical insolvency 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 bankruptc y Firm's liabilities exceed the market value of its assets. Courts treat technical insolvency and bankruptcy in the same way.

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

4 Largest Bankruptcies in U.S. History as of December 2, 2001 CompanyBankruptcy Date Total Assets, Prebankruptcy Enron Corp.December 2, 2001$63,392,000,000 Texaco, Inc.April 12, ,892,000,000 Financial Corp. of AmericaSeptember 9, ,864,000,000 Pacific Gas and Electric Co.April 6, ,470,000,000 MCorpMarch 31, ,228,000,000 First Executive Corp.May 13, ,193,000,000 Gibraltar Financial Corp.February 8, ,011,000,000 FINOVA Group, Inc.March 7, ,050,000,000 HomeFed Corp.October 22, ,885,000,000 Southeast Banking Corporation September 20, ,390,000,000 Reliance Group Holdings, Inc. June 12, ,598,000,000 Imperial Corp. of AmericaFebruary 28, ,263,000,000 Federal-Mogul Corp.October 1, ,150,000,000 Source: (January 3, 2002)

5 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:

6 Voluntary Liquidation Credit committee could recommend liquidation of the firm: Liquidation: privately or through the legal procedures provided by bankruptcy law Objective Recover as much per dollar owed as possible Alternative to liquidation - the firm is acquired

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.

8 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.

9 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.

10 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.

11 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.

12 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?

13 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.

14 Payment of Expenses 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

15 Payment of Expenses The company could be reorganized as follows Debentures (unsecured debt) $11,000,000 Subordinated debentures $14,000,000 Common 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!

16 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

17 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

18 Example: Liquidation of Oxford Company Oxford Company Balance Sheet AssetsLiabilities and Stockholders’ Equity Cash$3,000,000Accounts payable$5,000,000 Accounts receivable10,800,000Notes payable - bank23,000,000 Inventories45,000,000Accrued wages2,800,000 Current assets$58,800,000Unpaid employee benefits3,100,000 Net plant$27,200,000Unsecured customer deposits4,000,000 Net equipment20,000,000Taxes payable10,000,000 Net fixed assets$47,200,000 Total current liabilities$47,900,000 Total$106,000,000First mortgage$12,000,000

19 Balance Sheet of Oxford Company Oxford Company Balance Sheet AssetsLiabilities and Stockholders’ Equity Second mortgage$8,000,000 Subordinated debentures10,000,000 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

20 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 workers2,800,000 Unpaid employee benefits3,100,000 Unsecured customer deposits4,000,000 Taxes owed government10,000,000 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 assets4,000,000 Funds available for unsecured creditors10,100,000

21 Predicting Bankruptcy Z = 1.2 x X x X x X x X x X 5 Where X 1 = working capital / total assets X 2 = retained earnings / total assets X 3 = earnings before interest and taxes / total assets X 4 = market value of equity / book value of debt X 5 = 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 future About 80% accurate in forecasting bankruptcy two years in the future

22 Poff Industries Balance Sheet AssetsLiabilities and Stockholders’ Equity Cash$800,000Accounts payable$8,000,000 A/R12,000,000Notes payable - bank4,900,000 Inventories25,000,000 Total current liabilities$12,900,000 Current assets$37,800,000Mortgage$10,000,000 Land$9,000,000Debentures16,000,000 Net plant10,000,000 Total long-term debt$26,000,000 Net equipment14,000,000Preferred stock (100,000 shares)$5,000,000 Fixed assets$33,000,000Common stock (1 million shares)11,000,000 Total$70,800,000Paid-in capital in excess of par10,000,000 Retained earnings5,900,000 Total stockholders’ equity$31,900,000 Total$70,800,000

23 Income Statement of Poff Industries Poff Industries Income Statement Sales$62,000,000 Cost of goods sold38,000,000 Selling and administrative$12,000,000 Earnings before interest and taxes$12,000,000 Interest2,000,000 Earnings before taxes$10,000,000 Taxes (40%)6,000,000 Net income$4,000,000

24 Z score for Poff Industries Company’s stock price currently is $39 per share: Z = 1.2 x (0.35) x (0.083) x (0.17) x (1.5) x (0.88) = 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 –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.

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