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Assignment on the Marginal Firm

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

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CHAPTER 30 Financial Distress ■■■ 933

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 reor- ganization an attractive alternative to a private workout. There are some tax advantages to bankruptcy. Firms do not lose tax carryforwards in bankruptcy, and the tax treatment of the cancellation of indebtedness is better in bankruptcy. Also, interest on prebankruptcy 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 prebankruptcy 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.10 Under Chapter 11, the creditors are often forced to give up some of their seniority rights to get management and the equity investors to agree to a deal.

COMPLEXITY A firm with a complicated capital structure will have more trouble putting together a pri- vate workout. Firms with secured creditors and trade creditors such as Macy’s and Carter Hawley Hale will usually use formal bankruptcy because it is too hard to reach an agree- ment 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 incom- plete (complete). Complexity and lack of information make cheap workouts less likely.

Prepackaged Bankruptcy11 On March 14, 2014, sub shop Quiznos filed for Chapter 11 reorganization under the U.S. bankruptcy code. At the time, the company listed less than $1 million in assets and more than $500 million in liabilities. A firm in this situation could reasonably expect to spend

30.5

10 Journal of Financial Economics 27 (1990). However, William Beranek, Robert Boehmer, and Brooke Smith, in “Much Ado about Nothing: Absolute Priority Deviations in Chapter 11,” Financial Management (Autumn 1996), find that 33.8 percent of bankruptcy reorganizations leave the stockholders with nothing. They also point out that deviations from the absolute priority rule are to be expected because the bankruptcy code allows creditors to waive their rights if they perceive a waiver to be in their best interests. A rejoinder can be found in Allan C. Eberhart and Lawrence A. Weiss, “The Importance of Deviations from the Absolute Priority Rule in Chapter 11 Bankruptcy Proceedings,” Financial Management 27 (1998). 11John McConnell and Henri Servaes, “The Economics of Prepackaged Bankruptcy,” Journal of Applied Corporate Finance (Summer 1991), describe prepackaged bankruptcy.

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a year or more in bankruptcy. Not so with Quiznos group. Its reorganization plan was confirmed by the U.S. Bankruptcy Court on July 1, 2014, less than four months after the date of the filing!

Firms typically file bankruptcy to seek protection from their creditors, essentially admitting that they cannot meet their financial obligations as they are presently struc- tured. 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 in Chapter 11 depends on many things, but it usually depends most on the time it takes to get creditors to agree to a plan of reorganization.

Prepackaged bankruptcy is a combination of a private workout and legal bank- ruptcy. 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 Quiznos did.

The 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. Quiznos’ bankruptcy was painful for both stockholders and bondholders. Under the terms of the agreement, stockholders were wiped out entirely and three senior lenders exchanged $445 million in debt for 70 percent of the equity in the company and $200 million in new debt.

In another example of a prepack, let’s go back to the Atlantic City casino Revel we mentioned in our opener. Recall that it closed its doors in September 2014. On February 19, 2013, Revel Atlantic City filed for a prepack bankruptcy. Debt holders who put up $1.155 billion in February 2011 would own 82 percent of the company’s equity when it emerged from bankruptcy. On May 21, 2013, the company formally emerged from Chapter 11 bankruptcy. As an aside, in 2010, investment bank Morgan Stanley walked away from its entire $932 million investment in the company, so all-in-all, the Revel proved to be an expensive bet.

Prepackaged bankruptcy arrangements require that most creditors reach agree- ment privately. Prepackaged bankruptcy doesn’t seem to work when there are thou- sands of reluctant trade creditors, such as in the case of a retail firm like Macy’s or Revco D. S.12

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.13

A study by McConnell, Lease, and Tashjian reports that prepackaged bankruptcies offer many of the advantages of a formal bankruptcy, but they are also more efficient. Their

12Sris Chatterjee, Upinder S. Dhillon, and Gabriel G. Ramirez, in “Resolution of Financial Distress: Debt Restructurings via Chapter 11, Prepackaged Bankruptcies and Workouts,” Financial Management (Spring 1996), find that firms using prepackaged bankruptcy arrangements are smaller and in better financial shape and have greater short-term liquidity problems than firms using private workouts or Chapter 11. 13During bankruptcy, a proposed plan can be “crammed down” on a class of creditors. A bankruptcy court can force creditors to participate in a reorganization if it can be shown that the plan is “fair and equitable.”

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CHAPTER 30 Financial Distress ■■■ 935

results suggest that the time spent and the direct costs of resolving financial distress are less in a prepackaged bankruptcy than in a formal bankruptcy.14

Predicting Corporate Bankruptcy: The Z-Score Model Many potential lenders use credit scoring models to assess the creditworthiness of pro- spective borrowers. The general idea is to find factors that enable the lenders to discrimi- nate 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:

Z = 3.3 EBIT __________ Total assets + 1.2 Net working capital

_________________ Total assets

+ 1.0 Sales __________ Total assets + .6 Market value of equity

____________________ Book value of debt

+ 1.4 Accumulated retained earnings

___________________________ Total assets

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 nonbankruptcy if Z $ 2.99. Altman shows that bankrupt firms and nonbankrupt firms have very different financial profiles one year before bankruptcy.15 These different financial ratios are the key intuition behind the Z-score model and are depicted in Table 30.2.

30.6

14 John J. McConnell, Ronald Lease, and Elizabeth Tashjian, “Prepacks as a Mechanism for Resolving Financial Distress: The Evidence,” Journal of Applied Corporate Finance 8 (1996). 15 Although these are the original values proposed by Altman, in a more recent interview, he stated that a negative Z-score was now an indicator of potential bankruptcy. http://americasmarkets.usatoday.com/2014/09/18/z-score-predicts-doom-of-6-companies/.

Table 30.2 Financial Statement

Ratios One Year before Bankruptcy:

Manufacturing Firms

Average Ratios One Year before Bankruptcy of :

Bankrupt Firms Nonbankrupt Firms

Net working capital

________________ Total assets −6.1% 41.4%

Accumulated retained earnings

_________________________ Total assets −62.6% 35.5%

EBIT __________ Total assets −31.8% 15.4%

Market value of equity

__________________ Total liabilities 40.1% 247.7%

Sales ______ Assets 150 % 190 %

SOURCE: Edward I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993), Table 3.1, p. 109.

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EXAMPLE 30.3 U.S. Composite Corporation 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 an actively traded firm and market prices are not always very reliable, so the revised Z-score model can be used.

The balance sheet and income statement of U.S. Composite Corporation are in Tables 2.1 and 2.2 (Chapter 2).

The first step is to determine the value of each of the financial statement variables and apply them in the revised Z-score model:

($ in millions)

Net working capital

________________ Total assets = 275 _____ 1,879 = .146

Accumulated retained earnings

_________________________ Total assets = 390 _____ 1,879 = .208

EBIT __________ Total assets = 219 _____ 1,879 = .117

Book value of equity

_________________ Total liabilities = 805 ____ 588 = 1.369

The next step is to calculate the revised Z-score:

Z 5 6.56 3 .146 1 3.26 3 .208 1 1.05 3 .117 1 6.72 3 1.369

5 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.

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 nonmanufacturers. The resulting model is this:

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 gray area, and Z . 2.90 indicates no bankruptcy.

Summary and Conclusions This chapter examined what happens when firms experience financial distress.

1. Financial distress is a situation where a firm’s operating cash flow is not sufficient to cover contractual obligations. Financially distressed firms are often forced to take corrective action and undergo financial restructuring. Financial restructuring involves exchanging new financial claims for old ones.

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CHAPTER 30 Financial Distress ■■■ 937

2. Financial restructuring can be accomplished with a private workout or formal bankruptcy. Financial restructuring can involve liquidation or reorganization. However, liquidation is not as common.

3. Corporate bankruptcy involves Chapter 7 liquidation or Chapter 11 reorganization. An essential feature of the U.S. bankruptcy code is the absolute priority rule. The absolute priority rule states that senior creditors are paid in full before junior creditors receive anything. However, in practice the absolute priority rule is often violated.

4. A newer form of financial restructuring is prepackaged bankruptcy. It is a hybrid of a private workout and formal bankruptcy.

5. Firms experiencing financial distress can be identified by different-looking financial statements. The Z-score model captures some of these differences.

Concept Questions 1. Financial Distress Define financial distress using the stock-based and flow-based

approaches.

2. Financial Distress What are some benefits of financial distress?

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

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

5. Liquidation versus Reorganization What is the difference between liquidation and reorganization?

6. APR What is the absolute priority rule?

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

8. Bankruptcy Ethics Firms sometimes use the threat of a bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such cases the firm is using bankruptcy laws “as a sword rather than a shield.” Is this an ethical tactic?

9. Bankruptcy Ethics Several firms have entered bankruptcy, or threatened to enter bankruptcy, at least in part as a means of reducing labor costs. Whether this move is ethical, or proper, is hotly debated. Is this an ethical use of bankruptcy?

10. Bankruptcy versus Private Workouts Why do so many firms file for legal bankruptcy when private workouts are so much less expensive?

Questions and Problems 1. Chapter 7 When the Beacon Computer Company filed for bankruptcy under Chapter

7 of the U.S. bankruptcy code, it had the following balance sheet information:

Liquidating Value Claims

Trade credit $ 4,700 Secured mortgage notes 7,400 Senior debentures 12,000 Junior debentures 19,000

Total assets $31,400 Equity −11,700

BASIC (Questions 1–2)

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Assuming there are no legal fees associated with the bankruptcy, as a trustee, what distribution of liquidating value do you propose?

2. Chapter 11 When the Master Printing Company filed for bankruptcy, it filed under Chapter 11 of the U.S. bankruptcy code. Key information is shown here:

Assets Claims

Mortgage bonds $20,000 Senior debentures 10,500 Junior debentures 7,500

Going concern value $29,000 Book equity −9,000

As a trustee, what reorganization plan would you accept?

3. Z-Score 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 $95,000 EBIT 7,300 Net working capital 3,800 Book value of equity 21,000 Accumulated retained earnings 19,600 Sales 104,000

The stock price of FMM is $27 per share and there are 7,500 shares outstanding. What is the Z-score for this company?

4. Z-Score 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 $73,000 EBIT 7,900 Net working capital 4,200 Book value of equity 18,000 Accumulated retained earnings 16,000 Total liabilities 64,000

What is the Z-score for this company?

INTERMEDIATE (Questions 3–4)

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