Chapter 07: Financial Distress

.................Md. Jobayair Ibna Rafiq............

A Bankruptcy Case of Enron Corporation

Enron Corporation’s early 2002 bankruptcy (then the largest ever) was attributed mainly to

questionable partnerships set up by Enron’s CFO, Andrew Fastow. Those partnerships were

intended to hide Enron’s debt, inflate its profits, and enrich its top management. In late 2001,

these transactions lost large amounts of money, causing the corporation to file bankruptcy and

resulting in criminal charges against Enron’s key executives as well as its auditor, Arthur

Andersen, which failed to accurately disclose Enron’s financial condition.

 Chapter

Financial Distress
7
LEARNING OBJECTIVES
Chapter Outline
Financial Distress, Bankruptcy and Technical Insolvency
Causes of Business Failure
Bankruptcy, Liquidation and Reorganization
Predicting Corporate Bankruptcy
Questions and Solutions
Mathematical Problem
7.1. Financial Distress, Bankruptcy and Technical Insolvency

7.1.1. What is Financial Distress?

Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy
current obligations (such as trade credits or interest expenses) 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. Usually the firm
is forced to take actions that it would not have taken if it had sufficient cash flow. Financial
distress is surprisingly hard to define precisely. This is true partly because of the variety of
events befalling firms under financial distress. The list of events is almost endless, but here are
some examples:

 Dividend reductions
 Plant closings
 Losses Layoffs
 CEO resignations
 Plummeting stock prices
The definition of financial distress can be expanded somewhat by linking it to insolvency.
Insolvency is defined in Black’s Law Dictionary as:
"Inability to pay one’s debts; lack of means of paying one’s debts. Such a condition of a woman’s
(or man’s) assets and liabilities that the former made immediately available would be insufficient
to discharge the latter."
This definition has two general themes: stocks and flows. These two ways of thinking about
insolvency are depicted in Figure-01.
Stock-based insolvency occurs when a firm has negative net worth, so the value of assets is
less than the value of its debts.
Flow-based insolvency occurs when operating cash flow is insufficient to meet current
obligations. Flow-based insolvency refers to the inability to pay one’s debts. Insolvency may lead
to bankruptcy.
 Stock-Based Insolvency Flow-Based Insolvency

Figure 1: Stock & Flow Based Insolvency

7.1.2. Technical Insolvency

Technical insolvency also called accounting insolvency refers to a situation where the value of a
company's liabilities exceeds the value of its assets. Technical insolvency looks only at the
firm's balance sheet deeming a company 'insolvent on the books' when its net worth appears
negative. If technical insolvency persists, creditors and lenders might force the company to sell
assets or declare bankruptcy.

Factors That Affect Technical Insolvency

Contingent Liabilities. Possible or impending lawsuits can cause an increasing amount of liabilities
in the future that may ultimately exceed a company's assets. These contingent liabilities can
prevent the subject from functioning properly and can lead to both accounting and cash flow
insolvency.

Obsolesce of Technological Assets. Companies with a significant amount of fixed, long-term

assets on their balance sheet, such as property, buildings, and equipment, can run into problems,
too. If the assets become obsolete due to technological innovation, the value of the assets
technically declines, causing accounting insolvency.

Cash Flow Shortfalls. Cash flow shortfalls, meaning levels of cash flows that do not cover all of
the debt obligations, can be problematic. This state of liquidity crunch can force companies into
selling assets or profitable divisions to fund the cash flow shortfalls, triggering accounting
insolvency.

Cash Flow Insolvency vs. Technological Insolvency

Cash flow insolvency is different than accounting insolvency because a company might have the
assets to cover the liabilities, but not the cash flow. When there's not enough of the revenue
from sales being collected in the form of cash, the company risks failing to meet its short-term
debt obligations such as loan payments. Cash flow insolvency could occur, for example, if a
company had accounts payables—money owed to suppliers—due in the short term, and accounts
receivables—money owed by customers—not being paid in time to settle these bills. In some
cases, cash flow insolvency can be corrected by opening a short-term borrowing facility from a
bank. Companies can also negotiate better terms with suppliers, so they accept later payments
on their accounts' payables. In other words, just because a company becomes cash flow
insolvent, doesn't necessarily mean that bankruptcy is the only option.

Technological insolvency can be a much bigger issue for companies to navigate through since it
often involves long-term issues. If fixed assets have declined in value and the company needs to
liquidate them to pay debts, it might run into financial issues. Large assets are not easily sold in
the market or liquidated, and oftentimes the company takes a loss when comparing the sale
price versus the initial purchase price.

7.1.3. Bankruptcy

Bankruptcy occurs when the stated value of a firm’s liabilities exceeds the fair market value of
its assets. A bankrupt firm has a negative stockholders’ equity, which means that the claims of
creditors cannot be satisfied unless the firm’s assets can be liquidated for more than their book
value. Although bankruptcy is an obvious form of failure, the courts treat insolvency and
bankruptcy in the same way. They are both considered to indicate the financial failure of the
firm.

7.1.4. What Happens in Financial Distress?

Financial distress does not usually result in the firm’s death. Firms deal with distress in several
ways, such as these:
1. Selling major assets.
2. Merging with another firm.
3. Reducing capital spending and research and development.
4. Issuing new securities.
5. Negotiating with banks and other creditors.
6. Exchanging debt for equity.
7. Filing for bankruptcy.
Items (1), (2), and (3) concern the firm’s assets. Items (4), (5), (6), and (7) involve the right
side of the firm’s balance sheet and are examples of financial restructuring. Financial distress
may involve both asset restructuring and financial restructuring (i.e., changes on both sides of
the balance sheet). Some firms may
actually benefit from financial distress by
restructuring their assets. For example, a
levered recapitalization can change a
firm’s behavior and force a firm to dispose
of unrelated businesses. A firm going
through a levered recapitalization will add
a great deal of debt and, as a consequence,
its cash flow may not be sufficient to
cover required payments, and it may be
forced to sell its noncore businesses. For
some firms, financial distress may bring
about new organizational forms and new

Figure 2: What Happens in Financial Distress

operating strategies. Financial restructuring may occur in a private workout or a bankruptcy
reorganization.

Figure 2 shows how large public firms move through financial distress. Approximately half of
the financial restructurings have been done via private workouts. Most large public firms that
file for bankruptcy are able to reorganize and continue to do business.

7.1.5. Financial Distress and its Consequences

We begin with some background on financial distress and its consequences. A company’s intrinsic
value is the present value of its expected future free cash flows. Many factors can cause this
value to decline. These include general economic conditions, industry trends, and company-
specific problems such as shifting consumer tastes, obsolete technology, and changing
demographics in existing retail locations. Financial factors, such as too much debt and
unexpected increases in interest rates, can also cause business failures. The importance of the
different factors varies over time, and most business failures occur because a number of
factors combine to make the business unsustainable. Further, case studies show that financial
difficulties are usually the result of a series of errors, misjudgments, and interrelated
weaknesses that can be attributed directly or indirectly to management.

The Business Failure Record

Although bankruptcy is more frequent among smaller firms, it is clear from Table that large
firms are not immune. This was especially true in the Great Recession: Six of the largest
bankruptcies occurred in 2008 and 2009.

The Ten Largest Bankruptcies since 1980 (Billions of Dollars)

Company Business Assets Date
Lehman Brothers Holdings Inc. Investment banking $691.1 September 15, 2008
Washington Mutual Inc. Financial Service 327.9 September 26, 2008
WorldCom, Inc. Telecommunications 103.9 July 21, 2002
General Motors Corporation Auto Manufacturing 91.0 June 1, 2009
CIT Group Inc. Financial Service 80.4 November 1, 2009
Enron Corp. Energy Trading 63.4 December 2, 2001
Conseco Inc. Financial Service 61.4 December 17, 2002
Energy Future Holdings Corp. Electric Utility 50.0 April 29, 2014
MF Global Holdings Ltd. Commodities 40.5 October 31, 2011
Chrysler LLC Auto Manufacturing 39.3 April 30, 2009
Source: BankruptcyData.com, a division of New Generation Research, December 2016.

Bankruptcy obviously is painful for a company’s shareholders, but it also can be harmful to the
economy if the company is very large or is in a critical sector. For example, the failure of
Lehman Brothers in September 2008 sparked a global run on financial institutions that froze
credit markets and contributed to the ensuing global recession. It is not clear whether the
damage to the world economy could have been mitigated if the government had intervened to
prevent Lehman’s failure, but the government subsequently decided not to take chances with
many other troubled financial institutions. For example, the government helped arrange the
2008 acquisition of Wachovia by Wells Fargo, the 2008 acquisition of Bear Stearns by
JPMorgan Chase, and the 2009 acquisition of Merrill Lynch by Bank of America (despite Bank of
America’s misgivings). In addition, the government provided billions of dollars of capital to many
major financial institutions in 2008, including AIG. In each of these cases, the government
decided that a complete failure of these institutions might cause the entire financial system to
collapse.

In other cases, the government has decided that a company was too important to the
nonfinancial side of the economy to be allowed to go through liquidation. For example, in 2008
and 2009 the government provided billions of dollars of financing to General Motors and
Chrysler. Even though these companies subsequently went through bankruptcy proceedings in
2009, they avoided liquidation, still have a significant number of employees, and remain major
players in the automobile industry. In past years, the government also has intervened to support
troubled firms in other critical sectors, such as Lockheed and Douglas Aircraft in the defense
industry.

7.1.6. Issues Facing a Firm in Financial Distress

Financial distress begins when a firm is unable to meet scheduled payments or when cash flow
projections indicate that it will soon be unable to do so. As the situation develops, five central
issues arise.

1. Is the firm’s inability to meet scheduled debt payments a temporary cash flow problem, or is
it a permanent problem caused by asset values having fallen below debt obligations?

2. If the problem is temporary, then an agreement with creditors that gives the firm time to
recover and to satisfy everyone may be worked out. However, if basic long-run asset values have
truly declined, then economic losses have occurred. In this event, who should bear the losses,
and who should get whatever value remains?

3. Is the company “worth more dead than alive”? That is, would the business be more valuable if
it were liquidated and sold off in pieces or if it were maintained and continued in operation?

4. Should the firm file for protection under the Bankruptcy Act, or should it try to use informal
procedures? (Both reorganization and liquidation can be accomplished either informally or under
the direction of a bankruptcy court.)

5. Who should control the firm while it is being liquidated or rehabilitated? Should the existing
management be left in charge, or should a trustee be placed in charge of operations?

Review & Concept Questions

 What is financial distress?
 What is stock based insolvency and value based insolvency?
 Explain technical insolvency. What are factors that affect technical insolvency?
 What is bankruptcy? What happens in financial distress?
 What are the consequences of financial distress?
7.2. Causes of Business Failure

7.2.1. Business Failure

A business failure is an unfortunate circumstance. Although the majority of firms that fail to do
so within the first year or two of life, other firms grow, mature, and fail much later. The failure
of a business can be viewed in a number of ways and can result from one or more causes.

7.2.2. Types of Business Failure

There are many types of business failure. these are low or negative return, insolvency and
bankruptcy.

Low or Negative return. A firm may fail because its returns are negative or low. A firm that
consistently reports operating losses will probably experience a decline in market value. If the
firm fails to earn a return that is greater than its cost of capital, it can be viewed as having
failed. Negative or low returns, unless remedied, are likely to result eventually in one of the
following more serious types of failure.

Insolvency. A second type of failure, insolvency, occurs when a firm is unable to pay its
liabilities as they come due. When a firm is insolvent, its assets are still greater than its
liabilities, but it is confronted with a liquidity crisis. If some of its assets can be converted into
cash within a reasonable period, the company may be able to escape complete failure. If not, the
result is the third and most serious type of failure, bankruptcy.

Bankruptcy. Bankruptcy occurs when the stated value of a firm’s liabilities exceeds the fair
market value of its assets. A bankrupt firm has a negative stockholders’ equity, which means
that the claims of creditors cannot be satisfied unless the firm’s assets can be liquidated for
more than their book value. Although bankruptcy is an obvious form of failure, the courts treat
insolvency and bankruptcy in the same way. They are both considered to indicate the financial
failure of the firm.

7.2.3. Major Causes of Business Failure

There are many causes of Business failure:

Mismanagement. The primary cause of business failure is mismanagement, which accounts for
more than 50 percent of all cases. Numerous specific managerial faults can cause the firm to
fail. Overexpansion, poor financial actions, an ineffective sales force, and high production costs
can all singly or in combination cause failure.

Poor Financial Actions. Poor financial actions include bad capital budgeting decisions (based on
unrealistic sales and cost forecasts, failure to identify all relevant cash flows, or failure to
assess risk properly), poor financial evaluation of the firm’s strategic plans prior to making
financial commitments, inadequate or nonexistent cash flow planning, and failure to control
receivables and inventories. Because all major corporate decisions are eventually measured in
terms of dollars, the financial manager may play a key role in avoiding or causing a business
failure. It is the duty of the financial manager to monitor the firm’s financial pulse.
Economic Activity. Economic activity —especially economic downturns—can contribute to the
failure of a firm. If the economy goes into a recession, sales may decrease abruptly, leaving the
firm with high fixed costs and insufficient revenues to cover them. Rapid rises in interest rates
just prior to a recession can further contribute to cash flow problems and make it more
difficult for the firm to obtain and maintain needed financing.

Corporate Maturity. A final cause of business failure is corporate maturity. Firms, like
individuals, do not have infinite lives. Like a product, a firm goes through the stages of birth,
growth, maturity, and eventual decline. The firm’s management should attempt to prolong the
growth stage through research, new products, and mergers. Once the firm has matured and has
begun to decline, it should seek to be acquired by another firm or liquidate before it fails.
Effective management planning should help the firm to postpone decline and ultimate failure.

7.2.4. Voluntary Settlements

When a firm becomes insolvent or bankrupt, it may arrange with its creditors a voluntary
settlement, which enables it to bypass many of the costs involved in legal bankruptcy
proceedings. The settlement is normally initiated by the debtor firm because such an
arrangement may enable it to continue to exist or to be liquidated in a manner that gives the
owners the greatest chance of recovering part of their investment. The debtor arranges a
meeting between itself and all its creditors. At the meeting, a committee of creditors is
selected to analyze the debtor’s situation and recommend a plan of action. The recommendations
of the committee are discussed with both the debtor and the creditors, and a plan for
sustaining or liquidating the firm is drawn up.

Voluntary Settlement to sustain the firm

Normally, the rationale for sustaining a firm depends on whether the firm’s recovery is feasible.
By sustaining the firm, the creditor can continue to receive business from it. A number of
strategies are commonly used.

Extension. An extension is an arrangement whereby the firm’s creditors receive payment in full,
although not immediately. Normally, when creditors grant an extension, they require the firm to
make cash payments for purchases until all past debts have been paid.

Composition. A second arrangement, called composition, is a pro rata cash settlement of

creditor claims. Instead of receiving full payment of their claims, creditors receive only a
partial payment. A uniform percentage of each dollar owed is paid in satisfaction of each
creditor’s claim.

Creditor Control. A third arrangement is creditor control. In this case, the creditor committee
may decide that maintaining the firm is feasible only if the operating management is replaced.
The committee may then take control of the firm and operate it until all claims have been
settled. Sometimes, a plan involving some combination of extension, composition, and creditor
control will result. An example of this arrangement is a settlement whereby the debtor agrees
to pay a total of 75 cents on the dollar in three annual installments of 25 cents on the dollar,
and the creditors agree to sell additional merchandise to the firm on 30-day terms if the
existing management is replaced by new management that is acceptable to them.

Voluntary Settlement Resulting in Liquidation

After the situation of the firm has been investigated by the creditor committee, the only
acceptable course of action may be liquidation of the firm. Liquidation can be carried out either
privately or through the legal procedures provided by bankruptcy law. If the debtor firm is
willing to accept liquidation, legal procedures may not be required. Generally, the avoidance of
litigation enables the creditors to obtain quicker and higher settlements. However, all the
creditors must agree to a private liquidation for it to be feasible.

Process of Voluntary Liquidation. The objective of the voluntary liquidation process is to

recover as much per dollar owed as possible. Under voluntary liquidation, common stockholders
(the firm’s true owners) cannot receive any funds until the claims of all other parties have been
satisfied. A common procedure is to have a meeting of the creditors at which they make an by
passing the power to liquidate the firm’s assets to an adjustment bureau, a trade association, or
a third party, which is designated the assignee. The assignee’s job is to liquidate the assets,
obtaining the best price possible. The assignee is sometimes referred to as the trustee because
it is entrusted with the title to the company’s assets and the responsibility to liquidate them
efficiently. Once the trustee has liquidated the assets, it distributes the recovered funds to
the creditors and owners (if any funds remain for the owners). The final action in a private
liquidation is for the creditors to sign a release attesting to the satisfactory settlement of
their claims.

Review & Concept Questions

 What are the major causes of business failure?
 Do business failures occur evenly over time?
 Which size of firm, large or small, is most prone to business failure? Why?
 What are the three types of business failure? What is the difference between insolvency
and bankruptcy? What are the major causes of business failure?
 What is voluntary settlement?
 How they might be combined to form a voluntary settlement plan to sustain the firm.
 How is a voluntary settlement resulting in liquidation handled?
 Explain the process of voluntary liquidation.

7.3. Bankruptcy, Liquidation and Reorganization

When a firm experiences financial distress, its managers and creditors must decide whether
the problem is temporary and the firm is financially viable or whether a permanent problem
exists that endangers the firm’s life. Then the parties must decide whether to try to solve the
problem informally or under the direction of a bankruptcy court. Because of costs associated
with formal bankruptcy—including the disruptions that occur when a firm’s customers, suppliers,
and employees learn that it has filed under the Bankruptcy Act—it is preferable to reorganize
(or liquidate) outside of formal bankruptcy. We first discuss informal settlement procedures
and then the procedures under a formal bankruptcy.

7.3.1. Informal Reorganization

In the case of an economically sound company whose financial difficulties appear to be

temporary, creditors are generally willing to work with the company to help it recover and
reestablish itself on a sound financial basis. Such voluntary plans, commonly called workouts,
usually require a restructuring of the firm’s debt, because current cash flows are insufficient to
service the existing debt. Restructuring typically involves extension and/or composition. In an
extension, creditors postpone the dates of required interest or principal payments, or both. In a
composition, creditors voluntarily reduce their fixed claims on the debtor by accepting a lower
principal amount, by reducing the interest rate on the debt, by taking equity in exchange for
debt, or by some combination of these changes.

An informal debt restructuring begins with a meeting between the failing firm’s managers and
creditors. The creditors appoint a committee consisting of four or five of the largest creditors
plus one or two of the smaller ones. This meeting is often arranged and conducted by an
adjustment bureau associated with and run by a local credit managers’ association. The first
step is for management to draw up a list of creditors that shows the amounts of debt owed.
There are typically different classes of debt, ranging from first-mortgage holders to unsecured
creditors. Next, the company develops information showing the value of the firm under
different scenarios. Typically, one scenario is going out of business, selling off the assets, and
then distributing the proceeds to the various creditors in accordance with the priority of their
claims, with any surplus going to the common stockholders. The company may hire an appraiser
to get an appraisal of the value of the firm’s property to use as a basis for this scenario. Other
scenarios include continued operations, frequently with some improvements in capital equipment,
marketing, and perhaps some management changes.

7.3.2. Informal Liquidation

When it is obvious that a firm is more valuable dead than alive, informal procedures can also be
used to sell the firm’s asset in a liquidation.

Assignment is an informal procedure for liquidating a firm, and it usually yields creditors a
larger amount than they would get in a formal bankruptcy liquidation. However, assignments are
feasible only if the firm is small and its affairs are not too complex.

Assignee. An assignment calls for title to the debtor’s assets to be transferred to a third party,
known as an assignee or trustee. The assignee is instructed to liquidate the assets through a
private sale or public auction and then to distribute the proceeds among the creditors on a pro
rata basis. The assignment does not automatically discharge the debtor’s obligations. However,
the debtor may have the assignee write the requisite legal language on the check to each
creditor so that endorsement of the check constitutes acknowledgment of full settlement of
the claim.
What are the advantages of liquidation by assignment versus a formal bankruptcy
liquidation?

Assignment has some advantages over liquidation in federal bankruptcy courts in terms of time,
legal formality, and expense. The assignee has more flexibility in disposing of property than
does a federal bankruptcy trustee, so action can be taken sooner, before inventory becomes
obsolete or machinery rusts. Also, because the assignee is often familiar with the debtor’s
business, better results may be achieved. However, an assignment does not automatically result
in a full and legal discharge of all the debtor’s liabilities, nor does it protect the creditors
against fraud. Both of these problems can be reduced by formal liquidation in bankruptcy.

7.3.3. Bankruptcy Liquidation and Reorganization

Firms that cannot or choose not to make contractually required payments to creditors have two
basic options: Liquidation or reorganization. This section discusses bankruptcy liquidation and
reorganization.

 Very small firms are more likely to liquidate than reorganize compared to large firms.
 Firms with a large number of secured creditors are more likely to try to reorganize.
 Firms with an unsecured creditor, especially a bank, are more likely to choose liquidation.
 Firms that have large negative equity are more likely to try to reorganize.

Liquidation 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 established priority.

Reorganization is the option of keeping the firm a going concern; it sometimes involves issuing
new securities to replace old securities. Liquidation and formal reorganization may be done by
bankruptcy. Bankruptcy is a legal proceeding and can be done voluntarily with the corporation
filing the petition or involuntarily with the creditors filing the petition.

Bankruptcy Liquidation

In the case bankruptcy liquidation, The following sequence of events is typical:

1. A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary
petitions may be filed against the corporation.
2. A bankruptcy trustee is elected by the creditors to take over the assets of the debtor
corporation. The trustee will attempt to liquidate the assets.
3. When the assets are liquidated, after payment of the costs of administration, proceeds are
distributed among the creditors.
4. If any assets remain after expenses and payments to creditors, they are distributed to the
shareholders.

Priority of Claims

Once a corporation is determined to be bankrupt, liquidation takes place. The distribution of the
proceeds of the liquidation occurs according to the following priority:
1. Administration expenses associated with liquidating the bankrupt company’s assets.
2. Unsecured claims arising after the filing of an involuntary bankruptcy petition.
3. Wages, salaries, and commissions.
4. Contributions to employee benefit plans arising within 180 days before the filing date.
5. Consumer claims.
6. Tax claims.
7. Secured and unsecured creditors’ claims.
8. Preferred stockholders’ claims.
9. Common stockholders’ claims.
The priority rule in liquidation is the absolute priority rule (APR). One qualification to this list
concerns secured creditors. Liens on property are outside APR ordering. However, if the
secured property is liquidated and provides cash insufficient to cover the amount owed them,
the secured creditors join with unsecured creditors in dividing the remaining liquidating value.
In contrast, if the secured property is liquidated for proceeds greater than the secured claim,
the net proceeds are used to pay unsecured creditors and others.

Bankruptcy Reorganization

The general objective of a proceeding is to plan to restructure the corporation with some
provision for repayment of creditors. A typical sequence of events follows:
1. A voluntary petition can be filed by the corporation, or an involuntary petition can be filed by
three or more creditors (or one creditor if the total creditors are fewer than 12—see the
previous section). The involuntary petition must allege that the corporation is not paying its
debts.
2. Usually, a federal judge approves the petition, and a time for filing proofs of claims of
creditors and of shareholders is set.
3. In most cases, the corporation (the “debtor in possession”) continues to run the business.
4. For 120 days only the corporation can file a reorganization plan. If it does, the corporation is
given 180 days from the filing date to gain acceptance of the plan.
5. Creditors and shareholders are divided into classes. A class of creditors accepts the plan if
two-thirds of the class (in dollar amount) and one-half of the class (in number) have indicated
approval.
6. After acceptance by creditors, the plan is confirmed by the court.
7. Payments in cash, property, and securities are made to creditors and shareholders. The plan
may provide for the issuance of new securities.
However, it will be difficult for the firm to convince secured creditors (mortgage bonds) to
accept unsecured debentures of equal face value. In addition, the corporation may wish to allow
the old stockholders to retain some participation in the firm. Needless to say, this would be a
violation of the absolute priority rule, and the holders of the debentures would not be happy.

7.3.4. Private Workout or Bankruptcy: Which is Best?

A firm that defaults on its debt payments will need to restructure its financial claims. The firm
will have two choices: Formal bankruptcy or private workout. Both types of financial
restructuring involve exchanging new financial claims for old financial claims. Usually, senior
debt is replaced with junior debt and junior debt is replaced with equity. Much recent academic
research has described what happens in private workouts and formal bankruptcies.
Historically, half of financial restructurings have been private, but recently, formal
bankruptcies have dominated. Firms that emerge from private workouts experience stock price
increases that are much greater than those for firms emerging from formal bankruptcies. The
direct costs of private workouts are much less than the costs of formal bankruptcies. Top
management usually loses pay and sometimes jobs in both private workouts and formal
bankruptcies. These facts, when taken together, seem to suggest that a private workout is
much better than a formal bankruptcy.

Question: Why do firms ever use formal bankruptcies to restructure?

The Marginal Firm. For the average firm, a formal bankruptcy is more costly than a private
workout, but for other firms formal bankruptcy is better. 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. As a consequence, equity investors can usually hold out
for a better deal in bankruptcy. The absolute priority rule, which favors creditors over equity
investors, is usually violated in formal bankruptcies. One recent study found that in 81 percent
of recent bankruptcies the equity investor obtained some compensation.

Complexity. A firm with a complicated capital structure will have more trouble putting together
a private workout. Firms with secured creditors and trade creditors such as Macy’s and Carter
Hale will usually use formal bankruptcy because it is too hard to reach an agreement with many
different types of creditors.

Lack of Information. There is an inherent conflict of interest between equity investors and
creditors, and the conflict is accentuated when both have incomplete information about the
circumstances of financial distress. When a firm initially experiences a cash flow shortfall, it
may not know whether the shortfall is permanent or temporary. If the shortfall is permanent,
creditors will push for a formal reorganization or liquidation. However, if the cash flow shortfall
is temporary, formal reorganization or liquidation may not be necessary. Equity investors will
push for this viewpoint. This conflict of interest cannot easily be resolved. These last two points
are especially important. They suggest that financial distress will be more expensive (cheaper)
if complexity is high (low) and information is incomplete (complete). Complexity and lack of
information make cheap workouts less likely.

7.3.5. Prepackaged Bankruptcy

One type of reorganization combines the advantages of both the informal workout and formal
reorganization. This hybrid is called a prepackaged bankruptcy, or pre-pack. Prepackaged
bankruptcy is a combination of a private workout and legal bankruptcy. Prior to filing
bankruptcy, the firm approaches its creditors with a plan for reorganization. The two sides
negotiate a settlement and agree on the details of how the firm’s finances will be restructured
in bankruptcy. Then, the firm puts together the necessary paperwork for the bankruptcy court
before filing for bankruptcy. A filing is a prepack if the firm walks into court and, at the same
time, files a reorganization plan complete with the documentation of the approval of its
creditors, which is exactly what Choice One did.

In an informal workout, a debtor negotiates a restructuring with its creditors. Even though
complex workouts typically involve corporate officers, lenders, lawyers, and investment bankers,
workouts are still less expensive and less damaging to reputations. In a prepackaged bankruptcy,
the debtor firm gets all, or most, of the creditors to agree to the reorganization plan prior to
filing for bankruptcy. Then, a reorganization plan is filed along with, or shortly after, the
bankruptcy petition. If enough creditors have signed on before the filing, a cramdown can be
used to bring reluctant creditors along.

Firms typically file bankruptcy to seek protection from their creditors, essentially admitting
that they cannot meet their financial obligations as they are presently structured. Once in
bankruptcy, the firm attempts to reorganize its financial picture so that it can survive.

A key to this process is that the creditors must ultimately give their approval to the
restructuring plan. The time a firm spends depends on many things, but it usually depends most
on the time it takes to get creditors to agree to a plan of reorganization. Another key to the
prepackaged reorganization process is that both sides have something to gain and something to
lose. If bankruptcy is imminent, it may make sense for the creditors to expedite the process
even though they are likely to take a financial loss in the restructuring. Choice One’s bankruptcy
was relatively painless for most creditors. Interest payments were made on its debt while in
bankruptcy, and all vendors were paid. The prepack for Choice One was approved by 100 percent
of creditors.

Prepackaged bankruptcy arrangements require that most creditors reach agreement privately.
Prepackaged bankruptcy doesn’t seem to work when there are thousands of reluctant trade
creditors.

 What is benefits of Prepackaged Bankruptcy?

The main benefit of prepackaged bankruptcy is that it forces holdouts to accept a bankruptcy
reorganization. If a large fraction of a firm’s creditors can agree privately to a reorganization
plan, the holdout problem may be avoided. It makes a reorganization plan in formal bankruptcy
easier to put together. The time spent and the direct costs of resolving financial distress are
less in a prepackaged bankruptcy than in a formal bankruptcy.

Why would a firm that can arrange an informal reorganization want to file for bankruptcy?

The three primary advantages of a prepackaged bankruptcy are: (1) reduction of the holdout
problem, (2) preserving creditors’ claims, and (3) taxes. Perhaps the biggest benefit of a
prepackaged bankruptcy is the reduction of the holdout problem, because a bankruptcy filing
permits a cramdown that would otherwise be impossible. By eliminating holdouts, bankruptcy
forces all creditors in each class to participate on a pro rata basis, which preserves the relative
value of all claimants. Also, filing for formal bankruptcy can at times have positive tax
implications.

 First, in an informal reorganization in which the debt holders trade debt for equity, if the
original equity holders end up with less than 50% ownership then the company loses its
accumulated tax losses. In formal bankruptcy, in contrast, the firm may get to keep its loss
carry forwards.
 Second, in a workout, when (say) debt worth $1,000 is exchanged for debt worth $500, the
reduction in debt of $500 is considered to be taxable income to the corporation. However,
if this same situation occurs in a Chapter 11 reorganization, the difference is not treated as
taxable income.

All in all, prepackaged bankruptcies make sense in many situations. If sufficient agreement can
be reached among creditors through informal negotiations, a subsequent filing can solve the
holdout problem and result in favorable tax treatment. For these reasons, the number of
prepackaged bankruptcies has grown dramatically in recent years.

Review & Concept Questions

 Define an extension, a composition, restructuring, workouts, assignment and assignee
 What are informal reorganization and informal liquidation? Explain in detail.
 What are the advantages of liquidation by assignment versus a formal bankruptcy
liquidation?
 List the priority claim serially. Explain absolute priority rule.
 What are reorganization and liquidation?
 what are the sequences in case of bankruptcy liquidation and bankruptcy reorganization?
 Which is the best: private workouts or bankruptcy?
 Why do firms ever use formal bankruptcies to restructure?
 What prepackage bankruptcy or Pre-pack?
 What is benefits of Prepackaged Bankruptcy?
 Why would a firm that can arrange an informal reorganization want to file for bankruptcy?

7.4. Predicting Corporate Bankruptcy

7.4.1. Predicting Corporate Bankruptcy: The Z-Score Model

Many potential lenders use credit scoring models to assess the creditworthiness of prospective
borrowers. 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.

Edward Altman, a professor at New York University, has developed a model using financial
statement ratios and multiple discriminant analyses to predict bankruptcy for publicly traded
manufacturing firms. The resultant model is of the form:
Publicly Traded Manufacturing Firm:

EBIT Net WorkingCapital Sales Market Valueof Equity Accumulate

Z=3.3 +1.2 +1.0 +0.6 +1.4
Total Assets Total Assets Total Assets Book Value of Debt T

where Z is an index of bankruptcy.

A score of Z less than 2.675 indicates that a firm has a 95 percent chance of becoming
bankrupt within one year. However, Altman’s results show that in practice scores between 1.81
and 2.99 should be thought of as a gray area. In actual use, bankruptcy would be predicted if Z ≤
1.81 and non-bankruptcy if Z ≥ 2.99. Altman shows that bankrupt firms and nonbankrupt firms
have very different financial profiles one year before bankruptcy.

Private Firms and Non-manufacturers:

Altman’s original Z-score model requires a firm to have publicly traded equity and be a
manufacturer. He uses a revised model to make it applicable for private firms and non-
manufacturers. The resulting model is this:

Net Working Capital Accumulated Retained Earnings EBIT Book Value of

Z=6.56 +3.26 +1.05 +6.72
Total Assets Total Assets Total Assets Total Liabili

where Z < 1.23 indicates a bankruptcy prediction,

1.23 ≥ Z ≤ 2.90 indicates a gray area,

and Z > 2.90 indicates no bankruptcy.

Example
U.S. Composite Corporation, private owned firm, is attempting to increase its line of credit
with First National State Bank. The director of credit management of First National State
Bank uses the Z-score model to determine creditworthiness. U.S. Composite Corporation is not
a publicly traded firm, so the revised Z-score model must be used.
EBIT $219 Million
Net Working Capital $275 Million
Total Assets $1879 Million
Accumulated Retained Earnings $390 Million
Book Value of Equity $805 Million
Total Liabilities $588 Million
Solution: The first step is to determine the value of each of the financial statement variables
and apply them in the revised Z-score model:

Net Working Capital Accumulated Retained Earnings EBIT Book Value of

Z=6.56 +3.26 +1.05 +6.72
Total Assets Total Assets Total Assets Total Liabili
 $ 275 $ 390 $ 219 $ 805
Z=6.56 +3.26 + 1.05 +6.72
$ 1879 $ 1879 $ 1879 $ 588
= (6.56 × 0.146) + (3.26 × 0.208) + (1.05 × 0.117) + (6.72 × 1.369)

= 10.96

Finally, we determine that the Z-score is above 2.9, and we conclude that U.S. Composite is a
good credit risk meaning no bankruptcy prediction.

Review & Concept Questions

 What is Altman Z-score model?
 How can we predict corporate bankruptcy?
 What is the equation of Altman Z-score model?
 What are the coefficients for publicly traded firm and private firm in case Altman model?
 What are decision making criteria for publicly traded firm and private firm in case Altman
model?

7.5. Questions and Solutions

1. Define financial distress using the stock-based and flow-based approaches.

Answer: Financial distress is often linked to insolvency. Stock-based insolvency occurs when a
firm has a negative net worth. Flow-based insolvency occurs when operating cash flow is
insufficient to meet current obligations.

2. What are some benefits of financial distress?

Answer: Financial distress frequently can serve as a firm’s “early warning” sign for trouble.
Thus, it can be beneficial since it may bring about new organizational forms and new operating
strategies.

3. What is prepackaged bankruptcy? What is the main benefit of prepackaged

bankruptcy?

Answer: A prepackaged bankruptcy is where the firm and most creditors agree to a private
reorganization before bankruptcy takes place. After the private agreement, the firm files for
formal bankruptcy. The biggest advantage is that a prepackaged bankruptcy is usually cheaper
and faster than a traditional bankruptcy.

4. Why doesn’t financial distress always cause firms to die?

Answer: Just because a firm is experiencing financial distress doesn’t necessarily imply the firm
is worth more dead than alive.

5. What is the difference between liquidation and reorganization?

Answer: Liquidation occurs when the assets of a firm are sold and payments are made to
creditors (usually based upon the APR). Reorganization is the restructuring of the firm's
finances.

6. What is the absolute priority rule?

Answer: The absolute priority rule is the priority rule of the distribution of the proceeds of the
liquidation. It begins with the first claim to the last, in the order: administrative expenses,
unsecured claims after a filing of involuntary bankruptcy petition, wages, employee benefit
plans, consumer claims, taxes, secured and unsecured loans, preferred stocks and common
stocks.

7. What are DIP loans? Where do DIP loans fall in the APR?

Answer: Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt.
This new debt is called DIP (debtor in possession) debt. If DIP loans were not senior to all
other debt, a firm in bankruptcy would be unable to obtain financing necessary to continue
operations while in bankruptcy since the lender would be unlikely to make the loan.

8. Why do so many firms file for legal bankruptcy when private workouts are so much less
expensive?

Answer: There are four possible reasons why firms may choose legal bankruptcy over private
workout:
1) It may be less expensive (although legal bankruptcy is usually more expensive).
2) Equity investors can use legal bankruptcy to “hold out.”
3) A complicated capital structure makes private workouts more difficult.
4) Conflicts of interest between creditors, equity investors and management can make private
workouts impossible.

7.6. Mathematical Problem

1. Fair-to-Midland Manufacturing, Inc., (FMM) has applied for a loan at True Credit Bank. Jon
Fulkerson, the credit analyst at the bank, has gathered the following information from the
company’s financial statements:

Total Assets $42000

EBIT $6500

Net Working Capital$ $3100

Book Value of Equity $19000

Accumulated Retained Earnings $13500

Sales $61000

The stock price of FMM is $18 per share and there are 5,000 shares outstanding. What is the Z
score for this company?
Solution: Since we are given shares outstanding and a share price, the company must be publicly
traded. First, we need to calculate the market value of equity, which is:

Market value of equity = 5,000($18) = $90,000

We also need the book value of debt. Since we have the value of total assets and the book value
of equity, the book value of debt must be the difference between these two figures, or:

Book value of debt = Total assets – Book value of equity

Book value of debt = $42,000 – 19,000

Book value of debt = $23,000

Now, we can calculate the Z-score for a publicly traded company, which is:

EBIT Net WorkingCapital Sales Market Value of Equity Accumulated

Z=3.3 +1.2 +1.0 +0.6 +1.4
Total Assets Total Assets Total Assets Book Value of Debt To

Z-score = 3.3($6,500/$42,000) + 1.2($3,100/$42,000) + 1.0($61,000/$42,000)

+ .6($90,000/$23,000) + 1.4($13,500/$42,000)

Z-score = 4.8495

Finally, we determine that the Z-score is above 2.99, and we conclude that Fair-to-Midland
Manufacturing, Inc. is a good credit risk meaning no bankruptcy prediction.

2. Jon Fulkerson has also received a credit application from Seether, LLC, a private company. An
abbreviated portion of the financial information provided by the company is shown below:

Total Assets $75000

EBIT $8300

Net Working Capital$ $6800

Book Value of Equity $26000

Accumulated Retained Earnings $19000

Total Liabilities $49000

What is the Z-score for this company?

Solution: Since this company is private, we must use the Z-score for private companies and non-
manufacturers, which is:

Net Working Capital Accumulated Retained Earnings EBIT Book Value of E

Z=6.56 +3.26 +1.05 +6.72
Total Assets Total Assets Total Assets Total Liabilit

Z-score = 6.56($6,800/$75,000) + 3.26($19,000/$75,000) + 1.05($8,300/$75,000) +

6.72($26,000/$49,000)

Z-score = 5.103
Finally, we determine that the Z-score is above 2.9, and we conclude that Seether, LLC is a good
credit risk meaning no bankruptcy prediction.

Suggested Questions

Review and Concept questions

 What is financial distress?

 What is stock based insolvency and value based insolvency?
 Explain technical insolvency. What are factors that affect technical insolvency?
 What is bankruptcy? What happens in financial distress?
 What are the consequences of financial distress?
 What are the major causes of business failure?
 Do business failures occur evenly over time?
 Which size of firm, large or small, is most prone to business failure? Why?
 What are the three types of business failure? What is the difference between insolvency
and bankruptcy? What are the major causes of business failure?
 What is voluntary settlement?
 Explain how they might be combined to form a voluntary settlement plan to sustain the firm.
 How is a voluntary settlement resulting in liquidation handled?
 Explain the process of voluntary liquidation.
 Define an extension, a composition, restructuring, workouts, assignment and assignee
 What are informal reorganization and informal liquidation? Explain in detail.
 What are the advantages of liquidation by assignment versus a formal bankruptcy
liquidation?
 List the priority claim serially. Explain absolute priority rule.
 What are reorganization and liquidation?
 what are the sequences in case of bankruptcy liquidation and bankruptcy reorganization?
 Which is the best: private workouts or bankruptcy?
 Why do firms ever use formal bankruptcies to restructure?
 What prepackage bankruptcy or Prepack?
 What is benefits of Prepackaged Bankruptcy?
 Why would a firm that can arrange an informal reorganization want to file for bankruptcy?
 What is Altman Z-score model?
 How can we predict corporate bankruptcy?
 What is the equation of Altman Z-score model?
 What are the coefficients for publicly traded firm and private firm in case Altman model?
 What are decision making criteria for publicly traded firm and private firm in case Altman
model?
 What is Altman Z-score model?
 How can we predict corporate bankruptcy?
 What is the equation of Altman Z-score model?
 What are the coefficients for publicly traded firm and private firm in case Altman model?
 What are decision making criteria for publicly traded firm and private firm in case Altman
model?
 Why doesn’t financial distress always cause firms to die?
 What is the difference between liquidation and reorganization?
 What are DIP loans? Where do DIP loans fall in the APR?
 Why do so many firms file for legal bankruptcy when private workouts are so much less
expensive?