Chapter Thirty One
Financial Distress
Prepared by
Professor Wei Wang
Queen’s University
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Executive Summary
• This chapter discusses financial distress,
private workouts, and bankruptcy.
• A firm that defaults on a required payment
may be forced to liquidate its assets. More
often, a defaulting firm will reorganize.
• Financial restructuring involves replacing old
financial claims with new ones and takes
place with private workouts or legal
bankruptcy.
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Chapter Outline
31.1 What is Financial Distress?
31.2 What Happens in Financial Distress?
31.3 Bankruptcy Liquidation and Reorganization
31.4 Current Issues in Financial Distress
31.5 The Decision to Seek Court Protection: The Case
of Canwest Global Communications Corporation
31.6 Summary and Conclusions
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What is Financial Distress?
LO31.1
• 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.
• Usually the firm is forced to take actions that it
would not have taken if it had sufficient cash flow.
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Insolvency
LO31.1
• Stock-base insolvency; the value of the firm’s assets is less
than the value of the debt.
Solvent firm
Insolvent firm
Debt
Equity
Debt
Assets
Assets
Debt
Equity
Note the negative equity
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Insolvency
LO31.1
• 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
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The Largest U.S. Bankruptcies
Firm
Assets
(in $ billions)
LO31.1
Date
Lehman Brothers Holdings
$639.063
September 15, 2008
Washington Mutual
$327.913
September 26, 2008
Worldcom Inc.
$103.914
July 21, 2002
General Motors
$82.300
June 1, 2009
CIT Group
$71.019
November 11, 2009
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What Happens in Financial Distress?
LO31.2
• 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: The U.S.
Experience
LO31.2
No financial
restructuring
49%
Private
workout
Financial
distress
51%
47%
Financial
restructuring
53%
Reorganize
and emerge
83%
Legal bankruptcy
Chapter 11
7%
Merge with
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,
“Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).
Liquidation
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Responses to Financial Distress
LO31.2
• 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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Bankruptcy Liquidation and Reorganization LO31.3a
• Firms that cannot meet their obligations have two
choices: liquidation or reorganization.
• 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 priority.
• Reorganization 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
LO31.3b
Straight liquidation 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.
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Bankruptcy Liquidation: Priority of Claims
LO31.3b
The distribution of the proceeds of liquidation occurs according
to the following priority:
1. Administration expenses associated with liquidation.
2. Other expenses arising after the filing of an involuntary
bankruptcy petition.
3. Wages, salaries and commissions.
4. Municipal tax claims.
5. Rent.
6. Claims resulting from employee injuries.
7. Unsecured creditors.
8. Preferred shareholders.
9. Common shareholders.
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Example
LO31.3b
• Suppose the B.O. Drug Co. decides to liquidate.
• 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.
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Example (continued)
LO31.3b
Following our list of priorities, 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
Mortgage Bonds
$1,500,000
$1,500,000
Subordinated
Debentures
$2,500,000
$1,000,000
Common Stock
Total
$10,000,000
$14,000,000
$
0
$2,500,000
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Bankruptcy Reorganization
LO31.3b
A typical sequence:
1. A voluntary petition can be filed by the corporation or an
involuntary petition can be filed by creditors.
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 required to submit a reorganization plan.
5. Creditors and shareholders are divided into classes.
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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Reorganization Example
LO31.3b
• Suppose the B.O. Drug Co. decides to reorganize under the
Bankruptcy and Insolvency Act.
• Assume that the “going concern” value is $3 million and its
balance sheet is shown.
Assets
$3,000,000
Liabilities:
Equity
Mortgage bonds
$1,500,000
Subordinated
debentures
$2,500,000
-$1,000,000
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Reorganization Example
LO31.3b
The firm has proposed the following reorganization plan:
Old Security
Old Claim
New Claim Under
Reorganization
Mortgage bonds
$1,500,000
$1,500,000
Subordinated
debentures
$2,500,000
$1,000,000
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Reorganization Example
LO31.3b
And a distribution of new securities under a new
claim with the reorganization plan:
Old Security
New Claim Under Reorganization
Mortgage bonds
$1,000,000 in 9% subordinated
debentures
$500,000 in 11% subordinated
debentures
Subordinated debentures
$1,000,000 in 8% preferred stock
$500,000 in common stock
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Current Issues in Financial Distress
LO31.4
• 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?
LO31.4
•
•
•
In Canada, the current Bankruptcy and Insolvency
Act has added increased costs and time
commitments to the formal bankruptcy
proceedings.
Direct negotiations (private workouts) between
creditors and debtors can be expected to increase.
Bankruptcy is better for equity investors than for
creditors because equity investors can usually hold
out for a better deal in bankruptcy.
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Prepackaged Bankruptcy
LO31.4
• 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.
• 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 Decision to Seek Court Protection: The Case
of Canwest Global Communications Corp. LO31.5
•
•
•
•
Canwest, headquartered in Winnipeg, is one of Canada’s
largest international media companies.
The company was highly leveraged and too dependent on
advertisement revenue. The financial distress was caused
by issuing large amount of debt to finance various
ambitious acquisitions.
On October 6, 2009, Canwest filed for court protection in
Canada under the Companies’ Creditors Arrangement Act.
In February, 2010, Canwest found an investor, Shaw
Communications, to buy a controlling stake in the company
and help it reorganize. Bondholders bought out the
newspaper division in June 2010 for $1.1 billion.
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The Decision to Seek Court Protection: The Case
of Canwest Global Communications Corp. LO31.5
•
Costs of the Canwest restructuring include:
1. Direct costs of restructuring for the first six months.
Fees for Canwest Media
Fees for newspaper division
$87.7 million
$40.0 million
2. Indirect costs of restructuring: management distraction,
loss of customers, and loss of reputation.
3. Costs of a complicated financial structure: conflicts
between managers, shareholders, and creditors make
reaching a private agreement difficult.
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Summary and Conclusions
LO31.6
• Financial distress is a situation where a firm’s
operating cash flow is not sufficient to cover
contractual obligations.
• Financial restructuring can be accomplished with a
private workout or formal bankruptcy.
• Corporate bankruptcy involves liquidation or
reorganization.
• A hybrid of a private workout and formal
bankruptcy is prepackaged bankruptcy.
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Quick Quiz
• Define financial distress.
• Explain the absolute priority rule.
• Discuss why a private workout may be
preferred to formal bankruptcy.
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Appendix 31A: 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.
• Edward Altman has developed a model using
financial statement ratios and multiple discriminant
analyses to predict bankruptcy for publicly traded
manufacturing firms
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Predicting Corporate Bankruptcy: The Zscore model (continued)
• The resultant model is of the form:
Z = 3.3(EBIT/Total assets) + 1.2(Net working capital/Total
assets) + 1.0(Sales/Total assets) + 0.6(Market value of
equity/Book value of debt) + 1.4(Accumulated retained
earnings/Total assets)
where Z is an index of bankruptcy.
• Bankruptcy would be predicted if Z  1.81 and
nonbankruptcy if Z  2.99.
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Predicting Corporate Bankruptcy: The Zscore model (continued)
• Altman uses a revised model to make it applicable for
private firms and non-manufacturers.
• The resulting model is:
Z = 6.56(Net working capital/Total assets)
+ 3.26(Accumulated retained earnings/Total assets)
+ 1.05(EBIT/Total assets) + 6.72(Book value of equity/Total
liabilities)
where Z  1.23 indicates a bankruptcy prediction.
1.23  Z  2.90 indicates a grey area,
and
Z  2.90 indicates no bankruptcy.
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