TOWARDS A THEORY OF FINANCIAL DISTRESS M. J. Gorpon* For OVER TWENTY-FIVE YEARS the failure of a large American corporation has been an exceptional event explainable by circumstances peculiar to the cor- poration and of no general interest or significance. This has not always been the case, The great depression of the thirties and those that preceeded it resulted in failure and reorganization for many corporations. As a conse- quence, financial difficulty, bankruptcy and reorganization were important topics in corporation finance. For instance, the monumental text by Dewing [4] devoted one-third of the second volume to failure and reorganization, and much of the remainder of the book is devoted to preventing and dealing with financial distress. The journalistic accounts of the Penn Central failure indicate that it also was an exceptional event, poor management being the primary cause. What- ever the reasons, when so large and important a corporation fails, shortly after a merger that was expected to improve its fortunes, the failure deserves care- ful study. This I understand will be the concern of the other speakers. However, the Penn Central may not be due solely to circumstances peculiar to the company or even to the railroad industry. Corporate debt and interest rates have climbed to unprecedented levels and the government is committed to a policy of controlling inflation. Even without a severe depression these are circumstances in which some firms may be expected to fail. Accordingly it may be desirable for some of us to consider what the theory of finance can contribute towards understanding and dealing with the subject. In 1942 Dewing wrote “Indeed the development of the theory and practice of railroad reorganization is one of the most remarkable achievements of American business genius.”* The academicians with first-hand knowledge of the subject have left the scene of action. Some of us are old enough to vaguely recall their lectures on the subject. For most of us knowledge is limited to paging through a superficial chapter on bankruptcy and reorganization in an introductory text on finance. Anyone interested in applying the new theory of finance to this area should therefore begin with a careful reading of Dewing ‘or someone like him. Failure and reorganization are preceded by financial distress, and my pur- pose here is to raise some questions and take a few steps towards developing a theory of financial distress. Perhaps I should begin by defining the term financial distress. ‘The present theory on the relation between financial structure and security valuation assumes that the corporation’s senior securities are free of * University of Toronto. ‘The author has benefited from the assistance of Lawrence Gould in the research oa which this paper is based. 1. Dewing (4, p. 15311. 347348 The Journal of Finance default risk. This is true as long as the corporation’s debt is small in relation to its total value. However, a fall in a corporation's earning power will at some point create a non-trivial probability that it will not be able to pay the interest and principal on its debt. The corporation is then in a state of finan- cial distress, and its bonds sell at yields materially above the interest rates at which financial institutions are willing to extend credit to otherwise similar corporations. Next, let us raise some of the questions that a theory of financial distress should answer. What happens to the value of the common equity and the debt as a company falls into financial distress? Is the value of a company in finan- cial distress above, below, or the same as the value of the same company without the financial structure that is in part responsible for its financial dis- tress? What is the cost of capital for a company in financial distress? To ask the last question in a less precise but perhaps more meaningful way, does financial distress influence a firm’s ability to finance through various sources, and what are the attitudes of the stockholders and bondholders towards each source? As a starting point for the analysis, consider a real person with a net worth of W who borrows L and invests the sum V = W +L in a corporation's stock or a portfolio of shares. The individual is margin trading which means that the amount L is borrowed on call. As the market value of the stock owned changes L remains unchanged and W changes correspondingly. That is, aW/dV=1 and dL/av=0 a) As we all know, if V falls to L or slightly above L, the loan is called and the individual is wiped out. The broker will first call for more margin, but since Wis the individual's net worth, he is penniless and he is sold out? Consider now a corporation with a debt of L, a common equity of S, and a market of V=S-+L. The debt may vary in maturity, but for simplicity and in conformity with standard practice we assume it is a perpetuity, and the corporation's only obligation is to pay the periodic interest, C. Also, for simplicity we assume no corporate income tax. For the present, let us accept the Modigliani-Miller leverage theorem, V=S+L=X%p @) where X is the expected value of the periodic future earnings on assets and p is the rate at which X would be discounted in the absence of leverage. X is a random variable and if the probability that X < C is trivial, then L=C/i where i is the risk free interest rate. From one day to the next the probability distribution and mean of X may change, but for small changes in the distribution the probability X 0 we now have as/dX < dV/dX = 1/p (6) In words, as the firm's fortunes deteriorate part of the burden is shifted to the bondholder. Sharing the company's misfortunes with the bondholders is small consola- tion for the shareholders it may be argued. However, compare the situation of a shareholder in this levered corporation with what it would be if the corpora- tion’s assets were perfectly liquid and its debt had been obtained on a call loan. With the amount loaned Li = C/i, the value of the common equity would be Si =X/p—hi @ whereas the shareholders have S=X/p—la or 8 =K/p—ls ) With Ls < Ls < Lr it is clear that Ss > Sz > Si. ‘The above assumes that the value of the common equity is the value the firm would have in the absence of leverage less the value of the debt. It has been argued by Baxter [2], Altman [1], and others that bankruptcy impairs the value of a firm. If the firm’s value is also impaired as the probability of bankruptcy increases, S and perhaps L also will have lower values than those suggested above. However, it remains true that Sz and Ss will be larger than ‘We have just established that personal leverage is a very poor substitute for corporate leverage when the individual borrows on call and the corporation’s350 The Journal of Finance debt has no maturity." Corporations don’t issue consols but they do issue long term debt and preferred stock. Anyone who questions the assumption that in- dividuals are restricted to call loans should conduct the following experiment. Approach the loan office of a financial institution and request a million dollar loan to buy two million dollars worth of stock. Make clear that you want the Ioan with a maturity of ten years or longer and that security for the loan will be the two million dollars worth of stock which will be held by the financial institution, Be sure the loan officer understands that regardless of what happens to the value of the stock, the loan cannot be called until it matures, and at that time the financial institution gets the amount loaned or the value of the stock whichever is lower. If major financial institutions such as banks or insurance companies will grant such loans, the previous analysis has no merit. Restating and elaborating on Durand’s argument is justified by the fact that it has been all but ignored in the literature. Modigliani and Miller have stated, “Thus given corporate limited liability, a completely rigorous arbitrage proof . . . requires either the further restriction that X >rDz [rD.=C in our notation], or the assumption that . . . individuals as well as corporations are able to effectively limit their liability.” [7, pp. 594-595] Bonness [3] Stiglitz [8] and others have investigated the consequences of bankruptcy for the MM theorem. However, the empirical relevance of their formulation of the problem is open to question. Call borrowing provides an effective limit to an indi- vidual’s liability under personal leverage. The individual is wiped out when X/p falls to C/i. This does not bankrupt the corporation. In fact corporations do not become bankrupt even when X falls to C.* Some evidence on what happens to the values of a firm’s debt and common stock when it experiences financial distress is provided by looking at the major securities of the Milwaukee Road (Chicago, Milwaukee, St. Paul, and Pacific Railroad over the period December 31, 1966 to September 30, 1970. Table 1 shows the yields on the railroad’s major long term bonds and its preferred stocks.* The 4s 94 is a first mortgage. The other three bonds are income bonds with the Ss 2055 subordinated to the two 4 1/2s bonds. The 4 1/2s 2044 is convertible, and its yield is influenced by the price of the common when the latter is high, The interest on the income bonds must be payed only when earned, but the bonds are callable on the vote of 25% of the bonds outstand- 3. The previous analysis is largely an elaboration of the point raised by Durand [5] in his ‘comment on the Modigliani Miller theorem. 4, Friend and Blume (61 have found that portfolio returns do not increase with risk at as high a rate as the Sharpe capital asset pricing model predicts, This implies that individuals prefer leverage on cor sccount to personal leverage. Their explanation that “the borrowing rate for ‘an Investor is typically higher than the lending rate” (6, p. $69] is at best misleading. The interest rate on personal loans is not relevant and call loans can be obtained at about the same interest rate as the rate at which investors lend and corporations borrow. The preference for corporate leverage is due to the comparatively favorable terms under which corporations borrow as described above. 5. The securities not shown are the numerous short and medium term equipment trust certi- ‘ates and two small bonds of a 100% owned subsidiary. They were excluded since it is very difficult to obtain market values for these securities, but including them would only reinforce the conclusions to be reached351 A Theory of Financial Distress 96% 6 sre scar wore ier OF we 806 005 wit srez wu or awe oe ovor 599% svor zor OF over owe are ort seor ors. ore or sou 508 6 a6 we 56 or 289 9 ses, 508 re ore oe 859 ore 299 ore we we 01 696 59 we oro sv9 sre sre or a9 569 srg seo wt 05% oe 89 see sos 59s ore sre oe seo ove se9 re ae we O1 9961 99. 90% we woe wee 95% Or oss wo st9 ass ore are oe ms seo 19 uss 9 “9 or ws S65 a9 ss 9s 668 Ot 4961 zs as 669 93 us 9 Ov 5961 pasa ood veg, paused ” orse/ty 657 ‘aptig. 5 s/t FA ita O61 ‘OF WaNPEALEIG-996] ‘If WMMIIIG SETA WoOIg cTMAATLY ALI] save ROTOTIL ‘Ny aNog Yq §,Aco0jy GXY saxzTEno3g avOuTIVY D1aIDVG GNY “avd “As ‘aSMAVATITY ‘OOVOIND NIVIYa) NO SOTHLA IVAIMON 1 aTaVvL352 The Journal of Finance ing if the interest is not paid. Hence, these bondholders have the same recourse as ordinary bond holders when the interest on the bonds is not paid. Through the end of the second quarter of 1969 none of the nominal yields departed materially from the Baa yield." During the next four quarters the nominal yields rose in relation to the Baa, dramatically so for every secu but the 4s 94 first mortgage. The extent to which the prices of the senior securities fell during the period is shown in Table 2 where the price of each security is shown as a percentage of its December 31, 1966 price. TABLE 2 Quaxreety Marker Prices or Cexrain Citcaco, Mitwavxes, St. PAUt, AND Pactric RatbRoad SECURITIES EXPRESSED AS PERCENTAGES OF Tuein Decescsen 31, 1966 Prices December 31, 1966-September $0, 1970 CV 4 1/ ase 41/2819 “« S685 Preferred Common 1966 40 10000 110000 10000 100.00 10000 1100.00 1967 19 10226 99.08 134 10716 11329 13025 29 93.06 90.62 11248, 10131 11434 1073, 30 8715, 7938 106.76 9736 11189 13655 4Q 8281 nso 8849 9208 96.50 106.75, 1968 1Q 8056 nso 8735 9132 103.50 ons 29 3472 66 11092 92.08 11733 17011 30 420 7500 100.17 9233 13st 16407 196949 178 nso 9205 ons 10759 162.28 1969 10 1639 85 8735 8608 10559 138.08 20 7674 9344 7764 3000, 8392 102.14 39 6806 6625 66.55, 74.72 7343 6407 4Q 0044 6125 6031 37 S105 46.02 197010 5851 S598 3744 3170 3427 S409 2g S642 2000 2288 1660 13.99 2028 3 50.00 2438 3328 anar 238 3843 Table 2 also shows the price history of the common stock. It fell by at in the second quarter of 1969, and during the next three quarters it fell to one-third of its value on September 30, 1969. However, every security senior to it but the 4s 94 first mortgage fell even more drastically during these three quarters. Careful examination of the data reveals an interesting time pattern. Financial distress hit the common first, the preferred next and so on, Con- versely, during the third quarter of 1970 the common rose more than any other security with the first mortgage continuing to decline. Figure 1 is most interesting. It shows the market value of the firm, the par value of the securities senior to the common, these securities valued at the Baa yield, the market value of these senior securities, and the market value of the common stock. In the first quarter of 1968 and in the second quarter of 1969 the value of the firm fell below the par value of the senior securities. An 6. Why the 4s 94 ever sold at a higher yield than the 4 1/25 2019 is hard to explain. The 4 1/25 2044 convertible sold at low yields when the price of the common was high, The yield ‘on medium grade preferred stock was slightly below the Baa yield during this period, and Bence ‘the Baa yield can be used as a reference base for the Milwaukee Road's preferred stock.A Theory of Financial Distress 353 soo PARE VALEE OF FoI POO VALUE oF Dea (PAA Wioue oF Dex 100 2 Be tp f oa a ee individual with the same degree of personal leverage in an otherwise identical corporation would have been wiped out by December 31, 1967. It can be argued that it is incorrect to say that when the value of the firm falls to the par value of the senior securities the common equity would be wiped out if the leverage had been on personal account.’ Let us therefore take the Baa yield value of the senior securities as our reference point. In the first quarter of 1970 the value of the firm fell below the Baa yield value of the senior securities, and on June 30, 1970, the value of the firm had fallen to one- half the Baa value of the senior securities and less than one-quarter of the par value of the senior securities. Had the common been reduced to the value of wall paper? Quite the contrary, on September 30, 1970, the value of the com- mon was $29,000,000 with the Baa yield value of the debt $13,000,000 and the total value of the firm only $78,600,000. Furthermore, the common equity 17. However, if the senior securities were callable at par at the option of their owners and if the corporation could be liquidated at its market value, the conditions of leverage on personal ‘account, the common equity in the Milwaukee Road would have been wiped out at this point.354 The Journal of Finance was 37% of the firm’s value on that date, and only 33% of the firm’s value ‘on our reference date, December 31, 1966. Let us turn now from the consequences of financial distress for the values of a firm’s securities to its ability to finance new investment, With perfectly competitive capital markets and no financial distress a firm can finance an investment opportunity with a rate of return of x= p. That is the firm's value will be raised by the investment’s cost and the value of the previously out- standing securities will remain unchanged. If x > p, the investment of I raises the value of the outstanding common stock by I(x — p). Is the same true for a firm in financial distress? Consider first stock financing and assume that notwithstanding the finan- cial distress the investment will raise the firms value by its cost. However, the stock financing reduces the debt equity ratio. The consequence is that dL/aI > 1 and dS/dI < 1. Part of the increase in the firm’s value will accrue to the bondholders, and the shares can only be sold at 2 discount off the market price of the stock. The investment and its financing reduce the value of the existing common equity solely due to the firm’s financial structure. It will therefore not be in the interest of the present shareholders to undertake the stock financing unless the investment’s rate of return is substantially greater than p. Debt financing that has no priority over the existing debt poses even more difficult problems. The bonds must be sold at a nominal yield equal to the nominal yield on the outstanding debt. Financial institutions may hold debt that is selling at very high nominal yields, but they are unlikely to lend money on such terms for a variety of reasons. Ignoring this market imperfection, what would the consequences of borrowing to finance investment with the nominal yield on the debt above the expected return on the investment? I believe it can be shown that the value of the common stock would be raised but the value of the outstanding debt would be reduced. In that event the bondholders would not allow the new debt financing. An alternative is to issue debt that has a priority over the outstanding debt. This debt can be issued at a nominal rate equal to the risk free rate, and strange as it may seem new debt with a priority over the existing debt appears to be more advantageous to the existing bondholders than new debt with the same priority, The use of equipment trust certificates by the railroads illustrates this point, ‘The financing problems just mentioned, the costs of bankruptcy, and other market imperfections make financial distress an undesirable state of affairs. ‘That is the value of the firm would be increased by converting all or most of its senior securities into common stock. However, the stockholders would like to have market values the basis for conversion, while the bondholders would like to have the par or at least the risk-free value of the debt the basis for its conversion into common stock. If the gain from reorganization is small in relation to the sacrifice the bond and/or the share holders are required to make, voluntary reorganization is unlikely. ‘What happens to a firm in financial distress over time depends in part on the policy of the courts with respect to the reorganization of a firm in receiver-A Theory of Financial Distress 355 ship. Under the absolute priority rule, the old security holders receive dollar for dollar at par in the order of their seniority until the value of the firm is exhausted and the remaining security holders receive nothing. Under the relative priority rule all the old security holders with the possible exception of the common stockholders share in the new firm. Each receives a package of new securities that is worth a larger fraction of the old security's par value the higher its seniority. Insofar as I can tell the absolute priority rule is considered correct, while the relative priority rule is commonly used. Just how far the relative priority rule departs from the absolute priority is not clear, since the value of the firm and the value of the new securities are not pre- cisely determined at the time a reorganization is carried out. The empirical research needed for evidence on this question has not to my knowledge been undertaken, What is likely, however, is that even under the relative priority rule the common stockholders fare worse in a reorganization following a receivership than they would if the firm stayed out of receivership. Since receivership is also likely to change the management, both management and stockholders have an interest in delaying receivership as long as possible in the hope that a change in the firm’s fortunes will make it unnecessary. Receivership does not take place when X falls below C, X being no more than a theoretical con- struct. Receivership takes place when a court grants a petition for it by the creditors or the stockholders. The management will delay receivership by liquidating assets to meet obligations as they fall due. Creditors may not put the firm in receivership with the interest and/or principal on its debts past due for a variety of reasons, among them the desire to avoid the costs of the receivership. However at some point it is clear that the management is de- stroying the firm to avoid receivership and some creditors are getting dollar for dollar while the others will be left with an empty shell. At this point receivership takes place. If the declaration of receivership makes public what has been happening to the firm, the announcement will precipitate a sharp decline in the value of its securities.* ‘When if ever a firm in financial distress goes into receivership depends in part on the maturity structure of its debt and the amount of its non-operating liquid assets. Since the value of the firm and in particular the value of its common stock are reduced by receivership, financial structure is of some con- cern to the management and the stockholders. It is appropriate to conclude with the major questions to be answered in carrying out a reorganization: (1) what is the value of the firm apart from its financial structure? (2) what is the optimal financial structure? and (3) how shall the new securities be distributed among the old security holders? On the last question, is there a rationalization apart from expediency for the relative priority rule and if there is rationalization what is the optimum relative priority? The recent developments in the theory of finance and 83, Ingofar as the announcement has informational content on what has been taking place, Altman's (11 findings on the impact of receivership on the value of a firm are open to question. ‘That is, the announcement of receivership advises the market that the company is worse off than they had previously believed apart from the harmful consequences of the receivership.356 The Journal of Finance methods of empirical research may provide answers to these questions. It may also help a security owner evaluate how he would fare in a proposed reorganization plan. Since existing practice in carrying out reorganization is very time consuming and expensive, the development of a basis for expert opinion on the subject would appear to be a valuable contribution to knowl- edge. REFERENCES 1, Edward I. Altman. “Corporate Bankruptcy Potentitl, Stockholder Returns and Sbare Valua- tion,” Journal of Finance, Vol. XXIV, No. 5 (December 1965), pp. 887-900. 2, Nevins D. Baxter, “Leverage, Risk of Ruin and the Cost of Capital" Journal of Finance, Vol. XXII, No. 3 (September 1967), pp. 395-403. 3. A. James Boness. “A Pedagogic Note On The Cost of Capital,” Journal of Finance, Vol. XIX, No. 1 (March 1964), pp. 99-106. 4. Arthur S. Dewing. The Financial Policy Of Corporations, Fourth Ed, Vol. II (New York: Ronald Press, 1941). 5. David Durand. “The Cost of Capital, Corporation Finance, And The Theory of Investment: Comment," The American Economic Review, Vol. XLIX, No. 4 (September 1959), pp. 639-655. Irwin Friend and Marshall Blume. “Measurement Of Portfolio Performance Under. Uncer. tainty," The American Economic Review, Vol. LV, No. 4 (September 1970), pp. 561-575. 7, Franco Modigliani and Merton H. Miller. “Reply to Heins and Sprenkle,” The American Economic Review, Vol. LIX, No. 4, Part 1 (September 1969), pp. £92-895 8, Joseph. Stiglitz. “A Reexamination Of The Modighani-Miler Theorem” The American Economic Review, Vol. LIX, No. § (December 1969), pp. 784-793.