Professional Documents
Culture Documents
Financial Distress (2008)
Financial Distress (2008)
Debt Debt
Equity
Assets Assets
Equity Debt
Cash flow
shortfall
Contractual
obligations
Firm cash flow
Insolvency time
Why firms suffer financial distress?
Financial Private
distress workout
47%
51%
Financial Reorganize
restructuring and emerge
83%
53%
Legal bankruptcy 7% Merge with
Chapter 11 another firm
10%
Liquidation
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.
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.
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.
Bankruptcy Liquidation
Straight liquidation under Chapter 7 usually involves:
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.
Bankruptcy Liquidation: Priority of Claims
The distribution of the proceeds of liquidation
occurs according to the following priority (APR):
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.
APR (Absolute Priority Rule) Example
Suppose the B.O. Drug Co. decides to liquidate
under Chapter 7.
Assume that the liquidation value is $2.7 million.
Bonds worth $1.5 million are secured by a
mortgage on the corporate headquarters building,
which is sold for $1 million. $200,000 is used to
cover administrative costs and other claims—after
paying this, $2.5 million is available to pay
creditors. The only problem is that the unpaid debt
is $4 million.
APR (Absolute Priority Rule) Example
Under APR, all creditors are paid before shareholders, and
the mortgage bondholders are first in line. The trustee
proposes the following distribution:
Type of Claim Prior Claim Cash Received Under
Liquidation
Subordinated $2,500,000
debentures
Equity –$1,000,000
Reorganization Example
The firm has proposed the following
reorganization plan:
Old Security Old Claim New Claim Under
Reorganization