Why do firms ever use formal bankruptcies to restructure?

The Marginal Firm

Formal bankruptcy allows firms to issue debt that is senior to all previously incurred debt. This new
debt is “debtor in possession” (DIP) debt. For firms that need a temporary injection of cash, DIP debt
makes bankruptcy reorganization an attractive alternative to a private workout. There are some tax
advantages to bankruptcy. Firms do not lose tax carry forwards in bankruptcy, and the tax treatment of
the cancellation of indebtedness is better in bankruptcy. Also, interest on pre bankruptcy unsecured
debt stops accruing in formal bankruptcy.

Holdouts
Bankruptcy is usually better for the equity investors than it is for the creditors.

✓ Using DIP debt and stopping pre-bankruptcy interest from accruing on unsecured debt helps
the stockholders and hurts the creditors.

✓ The absolute priority rule, which favors creditors over equity investors, is usually violated in
formal bankruptcy. The creditors are often forced to give up some of their seniority rights to
get management and the equity investors to agree to a deal.

The Z-Score Model

The Altman Z Score model, defined as a financial model to predict the likelihood of bankruptcy in a
company, was created by Edward I. Altman. Altman was a professor at the Leonard N. Stern School
of Business of New York University. His aim at predicting bankruptcy began around the time of the
great depression, in response to a sharp rise in the incidence of default.

The Z-Score Model- Purposes

The purpose of the Z Score Model is to measure a company’s financial health and to predict the
probability that a company will collapse within 2 years. It is proven to be very accurate to forecast
bankruptcy in a wide variety of contexts and markets. The general idea is to find factors that enable
the lenders to discriminate between good and bad credit risks. To put it more precisely, lenders want
to identify attributes of the borrower that can be used to predict default or bankruptcy.