Executive Summary,This chapter discusses financial distress, private workouts, and bankruptcy. A firm that defaults on a required payment may be forced to liquidate its assets. More often, a defaulting firm will reorganize. Financial restructuring involves replacing old financial claims with new ones and takes place with private workouts or legal bankruptcy.,Chapter Outline,31.1 What is Financial Distress? 31.2 What Happens in Financial Distress? 31.3 Bankruptcy Liquidation and Reorganization 31.4 Private Workout or Bankruptcy: Which is Best? 31.5 Prepackaged Bankruptcy 31.6 Summary and Conclusions,31.1 What is Financial Distress?,A situation where a firms 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,Stock-base insolvency; the value of the firms assets is less than the value of the debt.,Debt,Insolvency,Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments.,Contractual obligations,Insolvency,$,Firm cash flow,time,The Largest U.S. Bankruptcies,31.2 What Happens in Financial Distress?,Financial distress does not usually result in the firms 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,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,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.,31.3 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,Straight liquidation under Chapter 7 usually involves: 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 firms 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,The distribution of the proceeds of liquidation occurs according to the following 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.,APR Example,Suppose the B.O. Drug Co. decides to liquidate under Chapter 7. Assume that the liquidation value is $2.7 million. Bonds worth $1.5 million are secured by a mortgage on the corporate headquarters building, which is sold for $1 million. $200,000 is used to cover administrative costs and other claimsafter paying this, $2.5 million is available to pay creditors. The only problem is that the unpaid debt is $4 million.,APR Example,Under APR, all creditors are paid before shareholders, and the mortgage bondholders are first in line. The trustee proposes the following distribution:,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