Chapter 30

Financial Distress

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Be able to define financial distress and understand what
happens to a firm in distress
 Understand the difference between liquidation and
reorganization
 Understand the absolute priority rule
 Understand the potential benefits of a private workout
versus formal bankruptcy
 Understand the Z-Score Model for predicting bankruptcy

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 Chapter Outline
30.1What Is Financial Distress?
30.2What Happens in Financial Distress?
30.3 Bankruptcy Liquidation and Reorganization
30.4 Private Workout or Bankruptcy: Which is Best?
30.5 Prepackaged Bankruptcy
30.6 Predicting Corporate Bankruptcy: The Z-Score Model

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30.1 What Is Financial Distress?
 Financial distress is a situation where a firm’s 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.

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Insolvency
 Stock-base insolvency: the value of the firm’s assets is less than
the value of the debt.

Solvent firm Insolvent firm

Debt Debt
Equity
Assets Assets
Equity Debt

Note the negative equity 30-4

 Insolvency
 Flow-base insolvency occurs when the firms cash flows
are insufficient to cover contractually required payments.

Cash flow
shortfall
Contractual
obligations
Firm cash flow

Insolvency time 30-5

 Largest U.S. Bankruptcies
Firm Liabilities Date
(in $ millions)
Lehman Bro. 613,000.00 September 2008

Conseco Inc. $56,639.30 December 2002

Worldcom Inc. 45,984.00 July 2002

Refco, Inc. 33,300.00 October 2005

Enron Corp. 31,237.00 December 2001

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30.2 What Happens in Financial
Distress?
 Financial distress does not usually result in the firm’s
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.

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 What Happens in Financial Distress?
No financial
restructuring
49%

Financial Private
distress workout
47%
51%
Financial Reorganize
restructuring and emerge
83%
53%
Legal bankruptcy 7% Merge with
Chapter 11 another firm

10%
Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics
27 (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,
Liquidation
“Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).
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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

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30.3 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.

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 Bankruptcy Liquidation
Straight liquidation under Chapter 7:
1. 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.
2. 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 firm’s assets.
3. After the assets are sold, after payment of the costs of
administration, money is distributed to the creditors.
4. If any money is left over, the shareholders get it.

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Bankruptcy Liquidation: Priority of Claims
Liquidation proceeds are distributed in order of priority:
1. Administration expenses associated with liquidation
2. Unsecured claims arising after the filing of an involuntary
bankruptcy petition
3. Wages earned within 90 days before the filing date, not to exceed
$2,000 per claimant
4. Contributions to employee benefit plans arising with 180 days
before the filing date
5. Consumer claims, not exceeding $900
6. Tax claims
7. Secured and unsecured creditors’ claims
8. Preferred stockholders’ claims
9. Common stockholders’ claims

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 Absolute Priority Rule in Practice
The APR states that senior claims are fully satisfied before junior
claims receive anything.
Deviations from APR
Equityholders Expectation: No payout
Reality: Payout in 81% of cases

Unsecured creditors Expectation: Full payout after

secured creditors
Reality: Violation in 78% of cases

Secured creditors Expectation: Full payout

Reality: Full payout in 92% of
cases 30-13
Reasons for Absolute Priority Rule
Violations
 Creditors want to avoid the expense of litigation. Debtors
are given a 120-day window of opportunity to cause delay
and harm value.
 Managers often own equity and demand to be compensated.
They are in charge for at least the next 120 days.
 Bankruptcy judges like consensual plans (they do not clog
the court calendar with appeals) and pressure parties to
compromise.

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 Bankruptcy Reorganization: Chapter 11
A typical sequence:
1. A voluntary petition or an involuntary petition is filed.
2. A federal judge either approves or denies the petition.
3. In most cases the debtor continues to run the business.
4. The firm is given 120 days to submit a reorganization plan.
5. Creditors and shareholders are divided into classes. Requires only
approval by 1/2 of creditors owning 2/3 of outstanding debt.
6. After acceptance by the creditors, the plan is confirmed by the court.
7. Payments in cash, property, and securities are made to creditors and
shareholders.

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30.4 Private Workout or Bankruptcy:
Which Is Best?
 Both formal bankruptcy and private workouts involve
exchanging new financial claims for old financial claims.
 Usually, senior debt is replaced with junior debt, and debt is
replaced with equity.
 When they work, private workouts are better than a formal
bankruptcy.
 Complex capital structures and lack of information make private
workouts less likely.

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Private Workout or Bankruptcy: Which Is
Best?
 Advantages of Bankruptcy
1. New credit is available - "debtor in possession" debt
2. Discontinued accrual of interest on pre-bankruptcy unsecured debt
3. An automatic stay provision
4. Tax advantages
5. Requires only approval by 1/2 of creditors owning 2/3 of outstanding
debt
 Disadvantages of Bankruptcy
1. A long and expensive process
2. Judges are required to approve major business decisions
3. Distraction to management
4. “Hold out” by stockholders

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30.5 Prepackaged Bankruptcy
 Prepackaged Bankruptcy is a combination of a private
workout and legal bankruptcy.
 The firm and most of its creditors agree to private
reorganization outside the formal bankruptcy.
 After the private reorganization is put together
(prepackaged) the firm files a formal bankruptcy (under
Chapter 11).
 The main benefit is that it forces holdouts to accept a
bankruptcy reorganization.
 Offers many of the advantages of a formal bankruptcy,
but is more efficient.

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The Z-Score Model: Public,
Manufacturers
 Credit scoring models provide a quick, objective way to
evaluate creditworthiness.
Altman’s Z-Score = 3.3*(EBIT/Total Assets) +
1.2*(NWC/Total Assets) + 1.0*(Sales/Total Assets) +
.6*(MV Equity / BV Debt) + 1.4* (Accumulated RE / Total
Assets)
◦ Z-Score < 1.81 indicates high probability of bankruptcy
◦ Z-Score between 1.81 and 2.99 is a grey area
◦ Z-Score > 2.99 indicates a low probability of bankruptcy

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The Z-Score Model: Private, Non-
Manufacturers
Altman’s Z-Score = 6.56*(NWC/Total Assets) +
3.26*(Accumulated RE / Total Assets) + 1.05* (EBIT/Total
Assets) + 6.72* (BV Equity / Total Liabilities)

 Z-Score < 1.23 indicates high probability of bankruptcy

 Z-Score between 1.23 and 2.90 is a grey area
 Z-Score > 2.90 indicates a low probability of bankruptcy

30-20
Quick Quiz
 Define financial distress.
 Contrast Chapter 7 versus Chapter 11 bankruptcy.
 Explain the absolute priority rule.
 Discuss why a private workout may be preferred to formal
bankruptcy.
 What key factors are considered in the Z-Score model for
predicting bankruptcy?

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