Business Failure | Bankruptcy In The United States | Bankruptcy

24 - 1

Bankruptcy, Reorganization, and Liquidation 

Financial distress process  Federal bankruptcy law  Reorganization  Liquidation

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What are the major causes of business failure? 

Economic factors 
industry weakness poor location/product 

Financial factors 
too much debt insufficient capital

Most failures occur because a number of factors combine to make the business unsustainable.

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Do business failures occur evenly over time? 

A large number of businesses fail each year, but the number in any one year has never been a large percentage of the total business population.  The failure rate of businesses has tended to fluctuate with the state of the economy.

4 What size firm.  Large firms tend to get more help from external sources to avoid bankruptcy. is more prone to business failure?  Bankruptcy is more frequent among smaller firms.24 . . large or small. given their greater impact on the economy.

5 What key issues must managers face in the financial distress process?  Is it a temporary problem (technical insolvency) or a permanent problem caused by asset values below debt obligations (insolvency in bankruptcy)?  Who should bear the losses?  Would the firm be more valuable if it continued to operate or if it were (More..) liquidated? .24 ..

24 . or should it try to use informal procedures?  Who would control the firm during liquidation or reorganization? .6  Should the firm file for bankruptcy.

24 .7 What informal remedies are available to firms in financial distress?  Informal reorganization  Informal liquidation  Why might informal remedies be preferable to formal bankruptcy?  What types of companies are most suitable for informal remedies? .

or both.) . Creditors prefer extension because they are promised eventual payment in full.24 . Extension: Creditors postpone the dates of required interest or principal payments..  Restructuring: Current debt terms are revised to facilitate the firm¶s ability to pay. (More.8 Informal Bankruptcy Terminology  Workout: Voluntary informal reorganization plan..

24 .9 Composition: Creditors voluntarily reduce their fixed claims on the debtor by either accepting a lower principal amount or accepting equity in lieu of debt repayment. . called a trustee or assignee. and then the assets are sold off.  Assignment: An informal procedure for liquidating a firm¶s assets. Title to the debtor¶s assets is transferred to a third party.

S. (More..) .  Trustee:  Appointed to control the company when current management is incompetent or fraud is suspected. bankruptcy law:  Chapter 11: Business reorganization guidelines.24 .  Chapter 7: Liquidation procedures.10 Describe the following terms related to U.. Used only in unusual circumstances.

.24 .  Involuntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm¶s creditors.11  Voluntary bankruptcy: A bankruptcy petition filed in federal court by the distressed firm¶s management.

) .12 What are the major differences between an informal reorganization and reorganization in bankruptcy?  Informal Reorganization: Less costly Relatively simple to create Typically allows creditors to recover more money and sooner.24 .. (More..

) . Interest and principal payments may be delayed without penalty until reorganization plan is approved.13  Reorganization in Bankruptcy Avoids holdout problems.24 . avoids common pool problem. Due to automatic stay provision.. (More..

Gives debtor exclusive right to submit a proposed reorganization plan for agreement from the parties involved. . Cramdown if majority in each creditor class approve plan. Reduces fraudulent conveyance problem.14 Permits the firm to issue debtor in possession (DIP) financing.24 .

 Plan filed with bankruptcy petition.24 .  Agreement to plan obtained from creditors prior to filing for bankruptcy.15 What is a prepackaged bankruptcy?  New type of reorganization Combines the advantages of both formal and informal reorganizations. Avoids holdout problems Preserves creditors¶ claims Favorable tax treatment. .

(More.  Secured creditors.16 List the priority of claims in a Chapter 7 liquidation...) .  Wages due workers within 3 months prior to filing.  Expenses incurred after involuntary case begun but before trustee appointed.24 .  Trustee¶s administrative costs.

 Unsecured claims for customer deposits.  Taxes due. .  Unfunded pension plan liabilities.  General (unsecured) creditors.  Preferred stockholders.17  Unpaid contributions to employee benefit plans that should have been paid within 6 months prior to filing.  Common stockholders.24 .

18 Liquidation Illustration Data (millions of $) Creditor Claims: Accounts payable Notes payable Accrued wages Federal taxes State and local taxes First mortgage Second mortgage Subordinated debentures* *Subordinated to notes payable.2 3.5 (More.0 0.3 0..0 $23.) . $10..0 0.0 5.5 4.24 .5 0.

19 Proceeds from liquidation: From current assets From fixed assets* Total receipts $14. .5 $16.0 2.5 * All fixed assets pledged as collateral to mortgage holders.24 .

0 $3.5 0.0 0.3 0.5 $1. (2) $16.0 Notes: (1) First mortgage receives entire proceeds from sale of fixed assets.5 $0. .0 0.5 $4.20 Priority Distribution (millions of $) Creditor Accrued wages Federal taxes Other taxes First mortgage Second mortgage Claim Distribution Unsatisfied $0.0 remains for distribution to general creditors.5 = $13.3 0.5 0.$3.5 .5 0.2 2.0 0.5 0.24 .5 $0.2 3. leaving $0 for the second mortgage.0 0.

500 65.0 5.a $6.21 General Creditor Distribution (millions of $) Creditor Accounts payable Notes payable Accrued wages Federal taxes Other taxes First mortgage Second mortgage Sub.0 0.65.000 Final Percent Amountb Received $6.200 100.0 0.0 $20.250 0.300 100.500 100.600 $13.0 0.5 4.0 0.325 0.0 0.825 94. deb.0 2. .2 0.0 Initial Distrib.2 $16.500 Pro rata amount = $13/$20 = 0. a b Remaining GC Claim $10.0 0.75 transfer from subordinated debentures. Includes priority distribution and $1.000 100.0% 5.325 65.0 0.24 .850 21.500 3.5 0.325 2.0 0.

some companies have used bankruptcy proceedings for other purposes: To break union contracts To hasten liability settlements .22 Other Motivations for Bankruptcy  Normally.24 .  However. bankruptcy is motivated by serious current financial problems.

and trustees.23 Some Criticisms of Bankruptcy Laws  Critics contend that current (1978) bankruptcy laws are flawed.  Companies in bankruptcy can hurt other companies in industry. leaving little for creditors when liquidation does occur.  Companies that have no hope remain alive too long. . managers.  Too much value is siphoned off by lawyers.24 .

24 Chapter 24 Extension  MDA to predict bankruptcy  Recent business failures .24 .

data from any firm can be entered into the model to assess the likelihood of future bankruptcy.24 .25 What is MDA. and how can it be used to predict bankruptcy?  Multiple discriminant analysis (MDA) is a statistical technique similar to multiple regression. .  Then.  It identifies the characteristics of firms that went bankrupt in the past.

26 MDA Illustration  Assume you have the following 2003 data for 12 companies: Current ratio Debt ratio  Six of the companies (marked by Xs) went bankrupt in 2004 while six (marked by dots) remained solvent. (More.24 ..) ..

..) = Solvent X = Bankrupt .27 Current Ratio Solvent Firms . . X X X .. X Bankrupt Firms Debt Ratio (More. . . X Discriminant Boundary X .24 .

) . (More..  Note that two companies have been misclassified by the MDA program: One bankrupt company falls on the solvent (left) side and one solvent company falls on the bankrupt (right) side. or Z line.24 .28  The discriminant boundary. statistically separates the bankrupt and solvent companies..

the future of the company is uncertain. .0(Debt ratio). bankruptcy is likely to occur. bankruptcy is unlikely.24 . if Z < -1. if Z = -1 to +1.5(Current ratio) .29  Assume the equation for the boundary line is Z = -2 + 1. If Z > 1.5.  Furthermore.

5(4.5.75) = -3. and firm is unlikely to go bankrupt.0. Then. Z = -2 + 1. .0 and DR = 0.30 Using MDA To Predict Bankruptcy  Suppose Firm S has CR = 4.0) .5. Z = -2 + 1.40) = +2.40.5(1.75. Then.24 . and firm is likely to go bankrupt.5) .  Suppose Firm B has CR = 1.0(0.5.5 and DR = 0.0(0.

 The more similar the historical sample to the firm being evaluated.24 .  Such models tend to work relatively well. the better the prediction.31 Some Final Points  The most well-known bankruptcy prediction model is Edward Altman¶s five factor model. but only for the near term. .

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