McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-1Corporate Finance Ross Westerfield JaffeSixth EditionSixth Edition31Chapter Thirty One Financial DistressMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-2 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.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-3 Chapter Outline31.1 What is Financial Distress?31.2 What Happens in Financial Distress?31.3 Bankruptcy Liquidation and Reorganization31.4 Private Workout or Bankruptcy: Which is Best?31.5 Prepackaged Bankruptcy31.6 Summary and ConclusionsMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-4 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.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-5 Insolvency Stock-base insolvency; the value of the firms assets is less than the value of the debt.AssetsDebtEquitySolvent firmDebtAssetsEquityInsolvent firmDebtNote the negative equityMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-6 Insolvency Flow-base insolvency occurs when the firms cash flows are insufficient to cover contractually required payments.Contractual obligationsInsolvency$Firm cash flowCash flow shortfalltimeMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-7 The Largest U.S. Bankruptcies FirmLiabilities ($m)Bankruptcy DateTexaco$21,6031987Executive Life Insurance14,5771991Mutual Benefit Life13,5001991Campeau9,9471990First Capital Holdings9,2911991Baldwin United9,0001983Continental Airlines (II)6,2001990Lomas Financial6,1271989Macys5,3001992McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-8 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.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-9Reorganize and emergeMerge with another firmLiquidation83%10%7%What Happens in Financial DistressFinancial distressFinancial restructuringNo financial restructuring49%51%Legal bankruptcy Chapter 11Private workout47%53%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 Empirical Study 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).McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-10 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 Euroyen are yen denominated deposits held outside Japan. Foreign bonds: bonds issued in another nations capital market by a foreign borrower. Gilts: British and Irish government securities. LIBOR: the London Interbank Offer Rate is the rate most international banks charge on another for loans of Eurodollars overnight in the London market.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-3132.2 Foreign Exchange Markets and Exchange Rates Without a doubt the foreign exchange market is the worlds largest financial market. In this market one countrys currency is traded for anothers. Most of the trading takes place in a few currencies.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.31-32 FOREX Market Participants The FOREX market is a two-tiered market: Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in Foreign exchange. Nonbank dealers account for about 20% of the market. There are FX br