Chapter 25:
Bankruptcy and Financial
Distress
Corporate Finance, 3e
Graham, Smart, and Megginson
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Bankruptcy and Business Failure
• A firm is insolvent whenever its liabilities exceed
its assets.
• Financial distress occurs when a company’s
cash flows are insufficient to pay its current
obligations.
• The term bankruptcy does not actually describe
a financial condition, but instead refers to a legal
process.
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2
Bankruptcy Law in the U.S.
Bankruptcy Reform Act of 1978: contains eight oddnumbered (1 through 15) chapters and chapter 12.
Chapter 7 contains procedures to be followed when
liquidating a failed firm.
Chapter 11 outlines the procedures for reorganizing a firm:



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Collective legal procedure is begun by which all claims are resolved.
An automatic stay prevents individual creditors from beginning
lawsuits against the debtor.
Debtor-in-possession (DIP)
Eliminates the benefit of being the first to sue because all claims
against the firm are settled simultaneously.
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Illiquidity
• In the early stages, a firm filing for chapter 11 frequently
faces problems with liquidity.

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Cash is depleted.
Lenders may threaten a declaration of default or covenant
violations.
Firm faces the loss of revolving credit lines.
Suppliers may demand to be paid in cash up front.
• The Bankruptcy Code authorizes the company to offer an
array of “sweeteners” to lenders who are willing to lend.
Under certain conditions, the firm may offer super-priority
to new lenders: the right to be paid ahead of everyone
else.
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Appointment
The filing firm becomes the debtor in possession (DIP) of
the assets:
Creditor committee appointed to represent the interest of
creditors.
DIP is responsible for the valuation of the firm.
 If
DIP evaluates the value as a going concern of
the firm lower than liquidation value, recommend
liquidation.
 Otherwise, DIP recommends reorganization.
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5
Reorganization Plan
DIP submits a reorganization plan to the court:
Key part of reorganization plan
Recapitalization
Debt is exchanged for equity or its maturity is
extended.
Claims on the new securities issued are distributed
based on the seniority of the existing claims.
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6
Acceptance of the
Reorganization Plan
Court approved plan is submitted for approval to
the firm’s creditors and shareholders.
Creditors and equity classes must agree with the
reorganization plan.
If creditors reject the plan, the debtor may seek a
cramdown, where a judge forces creditors to accept the
terms of the plan.
Absolute priority rule states that stockholders and lowpriority creditors can retain no interest in the reorganized
company unless all higher-priority creditors are paid in full.
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7
Sources of Aid to Firms that
Reorganize

Six major sources of aid come either
from the government or from creditors.

They give firms in reorganization
advantages relative to firms that
continue operating outside of bankruptcy
and firms that liquidate.
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8
Bankruptcy Act of 2005

Intended to prevent individuals and firms
from shirking their obligations too easily
by filing for bankruptcy

Key features of the 2005 Act
Limits the time incumbent management can
remain in control of the firm in chapter 11
 Limits bonuses that can be paid to retain
key employees while in chapter 11

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Overall, the chapter 11 process is now
more friendly to creditors.
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9
Alternatives to Chapter 11

Out-of-Court Workouts

Prepackaged Bankruptcies

Chapter 7
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Prepackaged Bankruptcies

Companies can prepare a reorganization
plan that is negotiated and voted on by
creditors and stockholders before the
company actually files for chapter 11
bankruptcy.

Shortens and simplifies the process and
saves money.
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11
Chapter 7: Liquidation in
Bankruptcy
Three
important
aspects
Procedures
Priority of claims
Final accounting
Chapter 7 of the Code addresses the order of
priority of claims.
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12
Predicting Bankruptcy
Altman’s Z score: Quantitative model that uses a blend of
traditional financial ratios and multiple discriminant analysis:
About 90% accurate in forecasting bankruptcy one year in the future
About 80% accurate in forecasting bankruptcy two years in the future
Z = 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5)
Where
X1 = Working capital / Total assets
X2 = Retained earnings / Total assets
X3 = Earnings before interest and taxes / Total assets
X4 = Market value of equity / Book value of debt
X5 = Sales / Total assets
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