financial distress

Chapter 30 Financial Distress828___

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Chapter 30Financial Distress

KEY NOTATIONS

APR Absolute Priority ruleCVA Company voluntary

agreementDIP Debtor in possession

(debt)Z Index of bankruptcy

If there is one thing that has characterized recent times, it is that many firms have become financially distressed. Because of the global credit crunch, which led to the worldwide recession in 2009, corporations have never been in such difficulty. In most industries demand for services and goods has plummeted, and at the time of writing the International Monetary Fund has predicted that global economic growth will be only 0.5 per cent in 2009. This is the worst economic performance since World War Two.

A firm that does not generate enough cash flow to make a contractually required payment, such as an interest payment, will experience financial

distress. A firm that defaults on a required payment may be forced to liquidate its assets. More often, a defaulting firm will reorganize its financial structure. Financial restructuring involves replacing old financial claims with new ones, and takes place with private workouts or legal bankruptcy. Private workouts are voluntary arrangements to restructure a company’s debt, such as postponing a payment or reducing the size of the payment. If a private workout is not possible, formal bankruptcy is usually required.

30.1 What Is Financial Distress?Financial distress is surprisingly hard to define precisely. This is true partly because of the variety of events befalling firms under financial distress. The list of events is almost endless, but here are some examples:

Dividend reductions•

Plant closings•

Losses•

Layoffs•

CEO resignations•

Plummeting share prices•

Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy current obligations (such as trade credits or interest expenses), and the firm is forced to take corrective action.1 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.

Our definition of financial distress can be expanded somewhat by linking it to insolvency. Insolvency is defined in Black’s Law Dictionary as2

Inability to pay one’s debts; lack of means of paying one’s debts. Such a condition of a woman’s (or man’s) assets and liability that the former made immediately available would be insufficient to discharge the latter.

PART e

IghT

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Finanza aziendale Stephen Ross, David Hillier, Randolph Westerfield, Jeffrey Jaffe, Bradford Jordan © 2012 McGraw-Hill

What happens in Financial Distress? 829 ___

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This definition has two general themes: value and flows.3 These two ways of thinking about insolvency are depicted in Fig. 30.1. Value-based insolvency occurs when a firm has negative net worth, so the value of assets is less than the value of its debts. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations. Flow-based insolvency refers to the inability to pay one’s debts.

30.2 What happens in Financial Distress?There are many responses to financial distress that a firm can make. These include one or more of the following turnaround strategies.

Asset expansion policies1

Operational contraction policies2

Financial policies3

External control activity4

Changes in managerial control5

Wind up company6

Asset expansion PoliciesIf a firm finds itself in difficulty, it may try to reduce the risk of its operations by increasing the size of its business or assets. Asset expansion policies include the full acquisition of another firm, a partial acquisition, setting up a new joint venture, increasing capital expenditure, higher levels of production, or expansion of existing facilities.

The joint venture between Fiat and Chrysler is a good example of an asset expansion policy. In 2009 carmakers were facing a bleak prospect, with sales down across the world. The US and British governments had already bailed out their own automobile industries, and many carmakers had reduced production to only part of the year. By entering into a joint venture, Fiat and Chrysler were able to expand their sales revenue at a time when they needed it the most.

Table 30.1 Large corporate bankruptcies since 2001

TA B L E

30.1 Company Country Year

Ssangyong Motor Company South Korea 2009

Nortel Networks United States 2009

Washington Mutual United States 2008

Sterling Airlines Denmark 2008

Sanlu group China 2008

Lehman Brothers holdings Inc. United States 2008

Kaupthing Bank Iceland 2008

hypo Real estate germany 2008

Yukos Russia 2006

Mg Rover United Kingdom 2005

Delta Air Lines, Inc. United States 2005

Parmalat Italy 2004

Worldcom Inc. United States 2002

Sabena Belgium 2001

enron Corp. United States 2001

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Chapter 30 Financial Distress 830___

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Operational Contraction PoliciesThe opposite of expansion is contraction, and many firms choose to focus on their most profitable businesses during a downturn. Operational contraction policies include asset sales, spin-offs and divestitures (see Chapter 29). Plants may also be closed, production can be cut, and employees made redundant. Redundancies are politically very sensitive, and many countries have very strong trade unions that can dramatically constrain the flexibility of firms when dealing with their own workforce.

Honda is a good example of following a contraction policy. First quarter results for 2009 were absolutely dire. Car sales had dropped by 10 per cent, and 400,000 fewer cars were sold than the same period in 2008. There was also the very strong possibility that the company would make an annual loss for the first time since it was founded in 1948. In response, Honda cut global production by 420,000 units and closed its UK plant for four months in order to reduce inventory levels. The employees of the British plant were still paid during this period and, as a result, no redundancies were made.

Financial PoliciesFinancially distressed firms will definitely face some type of cash liquidity problem. Several remedies are available. One, the company can reduce its annual dividend. Another option is to restructure existing debt facilities so that less interest is paid. The equity and debt markets may also be tapped to raise further funding.

F I G U R E

30.1

Figure 30.1 Insolvency

Solvent firm Insolvent firm

Negativeequity

Contractualobligations

Firm cash flow

Cash flowshortfall

Insolvency

Value-based insolvency occurs when the value of the assets of a firm is less than the valueof the debts. This implies negative equity. Flow-based insolvency occurs when firm cashflows are insufficient to cover contractually required payments.

Debt

Equity

Value

Assets

A. Value-based insolvency

B. Flow-based insolvency

Debt

Assets

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Bankruptcy Liquidation and Reorganization 831 ___

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During the global credit crunch many banks had to be bailed out by their governments with loan guarantees and equity share issues. In addition, almost every bank slashed its dividends to zero.

external Control ActivityExternal control activity means that the firm has been taken over, or an outside investor takes a significant stake in the firm. A change in external control means that one or more major shareholders sell their shares to another investor with a larger capital base and greater access to capital.

The European football industry has seen many deals of this type. One notable example is Glasgow Celtic, which was days away from bankruptcy when investor Fergus McCann purchased the shares of the club, imposed a very strict turnaround strategy, and reduced debt to almost zero. The team subsequently went on to dominate Scottish football, reached the UEFA cup final in 2003, and was one of only a few major British clubs to make a profit during the economic recession.

Changes in Managerial ControlThe ultimate penalty for poor performance is losing your job, and many firms opt to remove their chairman, chief executive or other directors when they are in financial distress. This will normally go hand in hand with other forms of restructuring. Examples include Fred Goodwin, the former chief executive of Royal Bank of Scotland, who had to step down after the bank found itself in serious financial difficulty as a result of the acquisition of Dutch bank ABN AMRO in 2007.

Wind up CompanyThe final and least desirable strategy a financially distressed firm will follow is to wind up its operations and go into some form of bankruptcy. Bankruptcy laws differ on a country-by-country basis, and even within the United Kingdom bankruptcy law is different in Scotland from the rest of the country. At the time of writing (2009), growth in corporate bankruptcies had rocketed as a result of the harsh economic conditions facing businesses. Bankruptcy may not always end in the disappearance of a company, and firms may be split up, sold on to a new buyer, or restructured during the process.

Figure 30.2 shows how large public firms move through financial distress in the US. Approximately half of the financial restructurings have been effected via private workouts. Most large public firms (approximately 70 per cent) that file for bankruptcy are able to reorganize and continue to do business.5

Firms in Europe follow a very similar process when they are financially distressed. For example, Table 30.2 presents the turnaround strategies of British firms that faced financial distress during the 1990s. The majority of firms reduced their scope of operations and under-went some form of financial restructuring.

Financial distress can serve as a firm’s ‘early warning’ system for trouble. Firms with more debt will experience financial distress earlier than firms with less debt. However, firms that experience financial distress earlier will have more time for private workouts and reorganization. Firms with low leverage will experience financial distress later and, in many instances, be forced to liquidate.

30.3 Bankruptcy Liquidation and ReorganizationFirms that cannot or choose not to make contractually required payments to creditors have two basic options: 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 established priority.

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Reorganization is the option of keeping the firm a going concern; it sometimes involves issuing new securities to replace old securities.

Liquidation and formal reorganization may be done by bankruptcy. Bankruptcy is a legal proceeding, and can be done voluntarily, with the corporation filing the petition, or involun-tarily, with the creditors filing the petition.

Bankruptcy LawBankruptcy law across the world is converging to a similar process. However, there are important country-level differences. The European Union introduced its bankruptcy regulation in 2002, ‘Regulation on Insolvency Proceedings’, which is followed by all EU countries, with the excep-tion of Denmark. As European bankruptcy law is very similar, the regulations facing British bankruptcy will be discussed in detail, followed by an overview of the salient differences in other countries.

Financially distressed firms in the UK can be voluntarily or compulsorily dissolved or liquidated. Liquidation means that the firm’s assets are sold to allow payment of the outstanding liabilities of the firm. However, this is the very last and least desirable option, and it will be considered only when all other strategies have been exhausted. An alternative is to appoint an administrator, who will attempt to restructure the firm’s outstanding claims, introduce a viable business model, or look for a potential buyer. It is important to note that when a firm is in administration, it will continue business until a solution (which may be liquidation) is found.

F I G U R E

30.2

Source: K.H. Wruck, ‘Financial distress: reorganization and organizational efficiency’, Journal of Financial Economics, vol. 27 (1990), Figure 2. See also S.C. Gilson, K. John and L.N.P. Lang, ‘Troubled debt restructuring: an empirical study of private reorganization of firms in defaults’, Journal of Financial Economics, vol. 27 (1990); and L.A. Weiss, ‘Bankruptcy resolution: direct costs and violation of priority of claims’, Journal of Financial Economics, vol. 27 (1990).

Figure 30.2 What happens in financial distress

Reorganize andemerge

83%

10%

7%

Privateworkout

Financialrestructuring

No financialrestructuring

53%

51%

Merge withanother firm

Legal bankruptcyChapter 11

Liquidation

Financialdistress

49%

47%

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Liquidation For a firm to be liquidated or made insolvent, a creditor, the directors, or share-holders must petition a court for a winding-up order. If a judge decides that there is a case for liquidation, an official receiver will be appointed, who liquidates the assets of the firm and distributes the proceeds to all creditors. Normally, creditors will not be paid all that they are due, because of direct bankruptcy costs from legal and administration fees.

Priority of Claims Once a corporation is determined to be bankrupt, liquidation takes place. The distribution of the proceeds of the liquidation occurs according to the following general priority:

Table 30.2 Turnaround strategies of financially distressed UK firms 1992–1998

TA B L E

30.2 Reported action Percentage of firms

Asset expansion policies

Full acquisition 32.46

Partial acquisition 4.55

Joint venture 8.44

Increase investment expenditures 0.65

Increase output / expand production facilities 2.60

Total 40.26

Asset contraction policies

Asset sale / spin-off / divestiture 29.87

Plant closure 1.30

Withdrawal from line of business 7.14

Unspecified cost-cutting programme 16.23

Cut in employment 13.64

Total 65.58

Financial policies

Cut dividend 45.45

Debt restructuring / renegotiation 1.95

Issue debt 4.55

Rights issue 3.90

Placing 6.49

Total 54.55

External control activity

Non-financial block purchase 0.65

Negotiations 4.55

Unsuccessful offer 0

Total 4.55

Change in managerial control

Ceo turnover 20.78

Forced ceo turnover 8.44

Total 20.78

Source: D. Hillier and P. McColgan, ‘Managerial discipline and firm responses to a decline in operating performance’, Working Paper (2007).

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Administration expenses associated with liquidating the bankrupt’s assets1

Unsecured claims arising after the filing of an involuntary bankruptcy petition2

Wages, salaries, and commissions3

Contributions to employee benefit plans arising within a set period before the filing date4

Consumer claims5

Tax claims6

Secured and unsecured creditors’ claims7

Preference shareholder claims8

Ordinary shareholder claims9

The priority rule in liquidation is known as the absolute priority rule (APR).One qualification to this list concerns secured creditors. Liens on property are outside APR

ordering. However, if the secured property is liquidated and provides cash insufficient to cover the amount owed them, the secured creditors join with unsecured creditors in dividing the remaining liquidating value. In contrast, if the secured property is liquidated for proceeds greater than the secured claim, the net proceeds are used to pay unsecured creditors and others.

EXAMPLE

30.1APRThe B.O. Deodorant Company is to be liquidated. Its liquidating value is £2.7 million. Bonds worth £1.5 million are secured by a mortgage on the B.O. Deodorant Company corporate headquarters building, which is sold for £1 million; £200,000 is used to cover

administrative costs and other claims (including unpaid wages, pension benefits, consumer claims, and taxes). After paying £200,000 to the administrative priority claims, the amount available to pay secured and unsecured creditors is £2.5 million. This is less than the amount of unpaid debt of £4 million.

Under APR, all creditors must be paid before shareholders, and the mortgage bondholders have first claim on the £1 million obtained from the sale of the headquarters building.

The trustee has proposed the following distribution:

Type of claimPrior claim

(£)

Cash received under liquidation

(£)

Bonds (secured by mortgage) 1,500,000 1,500,000

Subordinated debentures 2,500,000 1,000,000

Ordinary shareholders 10,000,000 0

Total 14,000,000 2,500,000

Calculation of the distribution (£)

Cash received from sale of assets available for distribution 2,500,000

Cash paid to secured bondholders on sale of mortgaged property 1,000,000

Available to bond and debenture holders 1,500,000

Total claims remaining (£4,000,000 less payment of £1,000,000 on secured bonds) 3,000,000

Distribution of remaining £1,500,000 to cover total remaining claims of £3,000,000

Type of claim remaining

Claim on liquidation

proceeds (£)Cash received

(£)

Bonds 500,000 500,000

Debentures 2,500,000 1,000,000

Total 3,000,000 1,500,000

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Administration When a company enters administration, the administrator will attempt to restructure the company’s liabilities, look for a buyer, or break up the company into viable parts. Possible strategies also include exchanging debt for equity, which allows the financially distressed firm to dispense with paying interest on debt, and at the same time gives the credi-tor a stake in the company should it recover.

The legal agreement that details how the firm’s liabilities are to be restructured is known as a company voluntary agreement (CVA). If creditors reject the CVA, or the company does not submit a CVA to the court, the judge can give the corporation an extension, during which it must come up with an acceptable plan or ask the creditors to come up with their own reorganization plan. In most cases at least one extension is granted. Under UK bankruptcy law a CVA will be accepted if at least 75 per cent of the company’s claimholders, including shareholders, vote in favour of it. Once accepted, the agreement is legally binding.

In Scotland bankruptcy law is slightly more complex. In addition to administration and insolvency procedures, firms may also go into receivership. This is also a characteristic of bankruptcy law in England and Wales for firms that have outstanding securities issued before 2003. The differences between administration and receivership are important. When in admin-istration, the financially distressed firm is legally protected from its creditors while a CVA is prepared. An insolvency practitioner, such as an accounting firm, is normally appointed to run the business while the agreement is being drawn up. A firm will go into receivership if its creditors do not believe that the company can recover and repay its liabilities. A receiver, again normally an accounting firm, will thus be appointed to sell the assets of the firm so that the creditors can be paid.

EXAMPLE

30.2Suppose B.O. Deodorant Co. decides to go into administration and reorganize. Generally, senior claims are honoured in full before various other claims receive anything. Assume that the ‘going concern’ value of B.O. Deodorant Co. is £3 million, and that its statement of financial position is as shown:

(£)

Assets 3,000,000

Liabilities

Mortgage bonds 1,500,000

Subordinated debentures 2,500,000

Shareholders’ equity −1,000,000

The firm has proposed the following reorganization plan:

Old securityOld claim

(£)

New claim with reorganization

plan (£)

Mortgage bonds 1,500,000 1,500,000

Subordinated debentures 2,500,000 1,500,000

and a distribution of new securities under a new claim with this reorganization plan:

Old security Received under proposed reorganization plan

Mortgage bonds £1,000,000 in 9% senior debentures

£500,000 in 11% subordinated debentures

Debentures £1,000,000 in 8% preference shares

£500,000 in ordinary shares

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However, it will be difficult for the firm to convince secured creditors (mortgage bonds) to accept unsecured debentures of equal face value. In addition, the firm may wish to allow the old shareholders to retain some participation in the firm. Needless to say, this would be a violation of the absolute priority rule, and the holders of the debentures would not be happy.

Bankruptcy in other countries Bankruptcy procedures in most countries follow the same model as that in the United Kingdom. In the United States financially distressed firms may file for Chapter 11 bankruptcy (equivalent to administration) or for Chapter 7 bankruptcy (equivalent to liquidation). All other aspects of the system are practically the same.

Countries in the European Union follow the 2002 ‘Regulation on Insolvency Proceedings’. Some country level differences do exist, however. Under Spanish insolvency law a creditors’ meeting is organized to form a CVA, and if it is not possible to come to an agreement, the firm will be liquidated. France has a three-stage process. The first stage involves pre-insolvency hearings, which can occur if the firm’s auditor is concerned about the financial health of the firm. If the hearings cannot resolve the auditor’s concerns, a petition will be made to a com-mercial court. The firm may at this point request a three-month window to draw up a CVA that will be acceptable to all parties. If this is unsuccessful, the firm will be wound up. Finally, although South Africa follows a similar system to other countries, there is no administration process. Thus creditors, shareholders, or the company itself will go directly to the South African High Court to request that the firm be placed in liquidation. The process is then worked through the system, and restructuring or winding-up may be an outcome of this process.

In Their Own Words

edward I. Altman* on Corporate Financial Distress and BankruptcyAs we entered the new millennium, corporate distress and bankruptcy were no longer a niche area of corporate evolution. The average company is far riskier today than it was just two decades ago, and the roles of the bankruptcy courts and restructuring specialists have never been more important. Financial distress of private and public entities throughout the world is a frequent occurrence with important implications to their many stakeholders. While the role of corporate bankruptcy laws is clear – either to provide a legal procedure that permits firms, which have temporary liquidity problems, to restructure and successfully emerge as continuing entities or to provide an orderly process to liquidate assets for the benefit of creditors before asset values are dissipated – bankruptcy laws differ markedly from country to country.

It is generally agreed that the US Chapter 11 provisions under the Bankruptcy Reform Act of 1978 provide the most protection for bankrupt firms’ assets and result in a greater likelihood of successful reorganization than is found in other countries where liquidation and sale of the assets for the benefit of creditors is more likely the result. But the US code’s process is usually lengthy (averaging close to two years, except where a sufficient number of creditors agree in advance via a prepackaged Chapter 11) and expensive, and the reorganized entity is not always successful in avoiding subsequent distress. If the reorganization is not successful, then liquidation under Chapter 7 will usually ensue.

Bankruptcy processes in the industrialized world outside the United States strongly favour senior creditors who obtain control of the firm and seek to enforce greater adherence to debt contracts. The UK process, for example, is speedy and less costly, but the reduced costs can result in undesirable liquidations, unemployment, and underinvestment. The new bankruptcy code in Germany attempts to reduce the considerable power of secured creditors but it is still closer to the UK system.

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Private Workout or Bankruptcy: Which Is Best? 837 ___

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Regardless of the location, one of the objectives of bankruptcy and other distressed workout

arrangements is that creditors and other suppliers of capital clearly know their rights and expected recoveries in the event of a distressed situation. When these are not transparent and/or are based on outdated processes with arbitrary and possibly corrupt outcomes, then the entire economic system suffers and growth is inhibited. Such is the case in several emerging-market countries. Revision of these outdated systems should be a priority.

* Edward I. Altman is Max L. Heine Professor of Finance, NYU Stern School of Business. He is widely recognized as one of the world’s experts on bankruptcy and credit analysis, as well as the distressed debt and high-yield bond markets.

30.4 Private Workout or Bankruptcy: Which Is Best?A firm that defaults on its debt payments will need to restructure its financial claims. The firm will have two choices: formal bankruptcy or private workout. The previous section described two types of formal bankruptcy: bankruptcy liquidation and bankruptcy reorganization. This section compares private workouts with bankruptcy reorganizations. Both types of financial restructuring involve exchanging new financial claims for old financial claims. Usually senior debt is replaced with junior debt, and debt is replaced with equity. Much recent academic research has described what happens in private workouts and formal bankruptcies.7

Historically, half of financial restructurings have been private, but recently formal bank-•ruptcy has dominated.

Firms that emerge from private workouts experience share price increases that are much •greater than those for firms emerging from formal bankruptcies.

The direct costs of private workouts are much less than the costs of formal bankruptcies.•

Top management usually loses pay and sometimes jobs in both private workouts and formal •bankruptcies.

These facts, when taken together, seem to suggest that a private workout is much better than a formal bankruptcy. We then ask: Why do firms ever use formal bankruptcies to restructure?

The Marginal FirmFor the average firm a formal bankruptcy is more costly than a private workout, but for some firms formal bankruptcy is better. Formal bankruptcy allows firms to issue debt that 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 reorganization an attractive alternative to a private workout. There are some tax advantages to bankruptcy. Firms do not lose tax carry-forwards in bankruptcy, and the tax treatment of the cancellation of indebtedness is better in bankruptcy. Also, interest on pre-bankruptcy unsecured debt stops accruing in formal bankruptcy.

holdoutsBankruptcy is usually better for the equity investors than it is for the creditors. Using DIP debt and stopping pre-bankruptcy interest on unsecured debt helps the shareholders and hurts the creditors. As a consequence, equity investors can usually hold out for a better deal in bankruptcy. The absolute priority rule, which favours creditors over equity investors, is usually violated in formal bankruptcies. One recent study found that in 81 per cent of recent bank-ruptcies the equity investor obtained some compensation.8 When a firm is in administration,

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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.

ComplexityA firm with a complicated capital structure will have more trouble putting together a private workout. Firms with secured creditors and trade creditors will usually use formal bankruptcy, because it is too hard to reach an agreement with many different types of creditor.

Lack of InformationThere 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 incomplete (complete). Complexity and lack of information make cheap workouts less likely.

Institutional FactorsMost research on corporate bankruptcies has looked at single countries, such as the United States and United Kingdom. However, an examination of only one country can mask the effect of important institutional factors that relate to the legal and corporate system. Davydenko and Franks (2008) look at the French, German and British systems of bankruptcy, and investigate whether their country-specific regulations impact upon the likelihood of firms going into and surviving formal administration.9

The legal bankruptcy systems in France, Germany and the UK fall under the umbrella of EU regulation. However, France and the UK represent two extremes in their approaches to resolving bankruptcy. Whereas France’s approach focuses on the debtor or borrowing firm, the UK is very much creditor- or lender-friendly. In France lenders have no input, beyond an advisory role, into the reorganization plan. This contrasts with the situation in the UK, where creditors can veto any reorganization plan that is put forward by the company. Germany is somewhere in between these two extremes.

Davydenko and Franks found that banks required higher levels of collateral when lending to French companies to offset the lower likelihood of receiving outstanding debts in the event of a default. Moreover, recovery rates (i.e. the percentage of outstanding debts that are received by creditors) are significantly higher in the United Kingdom (92 per cent) than in Germany (67 per cent) or France (56 per cent). Interestingly, British firms are more likely to survive administration, because their creditors, normally banks, are more likely to work with the financially distressed company to see it through the administration period.

30.5 Predicting Financial Distress: The Z-Score Model10

Many potential lenders use credit scoring models to assess the creditworthiness of prospective borrowers. The general idea is to find statistical factors that enable the lenders to discriminate 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 has developed a model using financial statement ratios and multiple dis-criminant analyses to predict bankruptcy for publicly traded manufacturing firms. The resultant model for US companies is of the form

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Predicting Financial Distress: The Z-Score Model 839 ___

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Z = × + ×3.3EBIT

Total assets1.2

Net working capitalTootal assets

1.0Sales

Total assets0.6

Market+ × + × vvalue of equityBook value of debt

1.4Accumul+ × aated 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 per cent 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 grey area. In actual use, bankruptcy would be predicted if Z ≤ 1.81 and non-bankruptcy if Z ≥ 2.99. Altman shows that bankrupt firms and non-bankrupt firms have very different financial profiles one year before bankruptcy. These different financial profits are the key intuition behind the Z-score model, and are depicted in Table 30.3.

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 non-manufacturers. The resulting model is this:

Z = × + ×6.56

Net working capitalTotal assets

3.26Accuumulated retained earnings

Total assets

+ 1.05E× BBIT

Total assets6.72

Book value of equityTotal

+ ×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.

EXAMPLE

30.3Consider the financial accounts of Sanofi-Aventis SA from Chapter 26. The company is publicly traded, but not a manufacturer, and so the modified Z-score model will be used. The alert reader will notice that the model uses accounting variables that are found in US accounting statements. International Financial Reporting Standards (IFRS) have slightly different

ways of presenting the information. For example, net working capital appears as current assets less current liabilities, and accumulated retained earnings appears in notes to the statement of financial position.

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

Net working capitalTotal assets

Current assets= −−

= −

Current liabilitiesTotal assets

12 553 9 669, ,71 994

0 040,

.=

Accumulated retained earnings

Total assets47,2= 77571,994

0.657=

EBIT

Total assets 71,9940.082= =5 911,

Book value of equity

Total liabilities= 44 719

27,,1195

= 1.644

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

Z = 6.56 × 0.040 + 3.26 × 0.657 + 1.05 × 0.082 + 6.72 × 1.644= 11.05

Finally we determine that the Z-score is above 2.9, and we conclude that Sanofi-Aventis is a good credit risk.

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Table 30.3 Financial statement ratios one year before bankruptcy: manufacturing firms

TA B L E

30.3 Bankrupt firms Non-bankrupt 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 liabilities40.1% 247.7%

Sales

Assets150% 190%

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

The same alert reader will also wonder why US Z-score coefficients can be used for a firm that is based in Europe. This would be a very good observation. In practice, banks use a variety of propriety prediction models when assessing the credit-worthiness of potential borrowers, and Altman’s Z-score model is just one of these. Another approach is to use neural networks to predict failure in borrowers. Irrespective of the model used, good-quality data on credit defaults is required in order to calibrate the coefficients. The coefficients in any model will clearly be a function of the borrower and lender demographics, institutional factors, and the quality of data that the analyst has in her possession. In practice, each country will have its own set of important variables and coefficients. All Altman’s model does is provide a predic-tion of failure, which is not a perfect prediction of the future. As a general indicator, the US coefficients can be used to provide some insight into the bankruptcy risk of corporations in other countries – only don’t take the outcome as particularly precise.

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

Financial distress is a situation where a firm’s operating cash flow is not sufficient to cover 1 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.

F2 inancial restructuring can be accomplished with a private workout or formal bankruptcy. Financial restructuring can involve liquidation or reorganization. However, liquidation is not common.

Corporate bankruptcy involves liquidation or reorganization. An essential feature of bank-3 ruptcy codes 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.

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Questions and Problems 841 ___

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Questions and Problems

Financial Distress 1 Define financial distress using the value-based and flow-based approaches.

What Happens in Financial Distress 2 Review the turnaround strategies that firms can follow when in financial distress. Which do you think are most effective? Why?

Bankruptcy Liquidation and Administration 3 What is the difference between admin-istration and reorganization? What are some benefits of financial distress?

Private Workouts and Bankruptcy 4 Do you think country-level institutional factors affect the turnaround strategies financially distressed firms may adopt? Explain.

Predicting Financial Distress 5 Review the variables in Altman’s Z-score model. Why do you think these variables are important in predicting financial distress?

F 6 inancial Distress Why doesn’t financial distress always cause firms to die?

APR 7 What is the absolute priority rule?

DIP Loans 8 What are DIP loans? Where do DIP loans fall in the APR?

Bankruptcy Ethics 9 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?

Bankruptcy Ethics10 Several firms have entered bankruptcy, or threatened to enter bank-ruptcy, at least in part, as a means of reducing labour costs. Whether this move is ethical, or proper, is hotly debated. Is this an ethical use of bankruptcy?

Bankruptcy versus Private Workouts11 Why do so many firms file for legal bankruptcy when private workouts are so much less expensive?

Administration12 When Beacon Computers entered insolvency, it had the following balance sheet information:

Liquidating value (£) Claims (£)

Trade credit 3,000

Secured mortgage notes 6,000

Senior debentures 5,000

Junior debentures 9,000

Total assets 15,500 Book equity −7,500

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

Administration13 When Masters Printing filed for bankruptcy, it entered administration. Key information is shown here:

Assets (£) Claims (£)

Mortgage bonds 10,000

Senior debentures 6,000

Junior debentures 4,000

going concern value 15,500 Book equity −5,000

As trustee, what reorganization plan would you accept?

CONCEPT

1–5

REGULAR

6–11

CHALLENGE

12–13

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Practical Case StudyIt is not difficult to find firms that are in financial distress. Download the financial accounts for five firms in your country that have performed poorly over the last year. Carry out a Z-score analysis for these companies. Now download the financial accounts for five firms that performed strongly in the past year and carry out a similar analysis. Are the Z-scores for the poor performance sample different from the good performance sample? Write a report on your analysis.

Relevant Accounting StandardsMany financially distressed firms choose to restructure their assets and sell off poorly per-forming divisions. An important standard in this regard is IAS37 Provisions, Contingent Liabilities and Contingent Assets. If firms wish to sell off divisions or non-current assets, they should also be familiar with IFRS5 Non-Current Assets Held for Sale and Discontinued Operations.

Additional ReadingFinancial distress is another topic that has taken on a new lease of life in recent years because of the unprecedented events in the world economy. The literature can be separated into factors that influence financial distress and turnaround strategies once a company is in trouble.

Predictors of DistressAcharya, V.V., S.T. Bharath and A. Srinivasan (2007) ‘Does industry-wide distress affect defaulted

firms? Evidence from credit recoveries’, Journal of Financial Economics, vol. 85, no. 3, pp. 787–821. US.

Agarwal, V. and R. Taffler (2008) ‘Comparing the performance of market-based and accounting-based bankruptcy prediction models’, Journal of Banking and Finance, vol. 32, no. 8, pp. 1541–1551. UK.

Braun, M. and B. Larrain (2005) ‘Finance and the business cycle: international, inter-industry evidence’, Journal of Finance, vol. 60, no. 3, pp. 1097–1127. International.

Campbell, J.Y., J. Hilscher and J. Szilagyi (2008) ‘In search of distress risk’, Journal of Finance, vol. 63, no. 6, pp. 2899–2939. US.

Yang, L. (2008) ‘The real determinants of asset sales’, Journal of Finance, vol. 63, no. 5, pp. 2231–2262. US.

Turnaround Strategies and the Bankruptcy ProcessBates, T.W. (2005) ‘Asset sales, investment opportunities, and the use of proceeds’, Journal of

Finance, vol. 60, no. 1, pp. 105–135. US.Bris, A., I. Welch and N. Zhu (2006) ‘The costs of bankruptcy: Chapter 7 liquidation versus

Chapter 11 reorganization’, Journal of Finance, vol. 61, no. 3, pp. 1253–1303. US.Brown, D.T., B.A. Ciochetti and T.J. Riddiough (2006) ‘Theory and evidence on the resolution

of financial distress’, Review of Financial Studies, vol. 19, no. 4, pp. 1357–1397. US.Davydenko, S.A. and J.R. Franks (2008) ‘Do bankruptcy codes matter? A study of defaults in

France, Germany and the UK’, Journal of Finance, vol. 62, no. 2, pp. 565–608. Europe.Eckbo, B.E. and K. Thorburn (2009) ‘Creditor financing and overbidding in bankruptcy auc-

tions: theory and tests’, Journal of Corporate Finance, vol. 15, no. 1, pp. 10–29. Sweden.Eisdorfer, A. (2008) ‘Empirical evidence of risk shifting in financially distressed firms’, Journal

of Finance, vol. 62, no. 2, pp. 609–637. US.Faccio, M., R.W. Masulis and J.J. McConnell (2006) ‘Political connections and corporate bailouts’,

Journal of Finance, vol. 16, no. 6, pp. 2597–2635. International.

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endnotes 843 ___

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Hillier, D., A. Marshall, P. McColgan and S. Werema (2007) ‘Employee layoffs, shareholder wealth and firm performance: evidence from the UK’, Journal of Business Finance and Accounting, vol. 34, nos. 3/4, pp. 467–494. UK.

Jostarndt, P. and Z. Sautner (2008) ‘Financial distress, corporate control, and management turnover’, Journal of Banking and Finance, vol. 32, no. 10, pp. 2188–2204. Germany.

Lee, E. and S. Lin (2008) ‘Corporate sell-offs in the UK: use of proceeds, financial distress and the long-run impact on shareholder wealth’, European Financial Management, vol. 14, no. 2, pp. 222–242. UK.

Other Relevant ResearchOngena, S., D.C. Smith and D. Michalsen (2003) ‘Firms and their distressed banks: lessons

from the Norwegian banking crisis’, Journal of Financial Research, vol. 67, no. 1, pp. 81–112. Norway.

Endnotes 1 This definition is close to the one used by K. Wruck, ‘Financial distress: reorganization and organiza-

tion efficiency’, Journal of Financial Economics, vol. 27 (1990), p. 425.

2 Black’s Law Dictionary, 5th ed. (St. Paul, MN: West Publishing Company), p. 716.

3 Edward Altman was one of the first to distinguish between stock-based insolvency and flow-based insolvency. See E. Altman, Corporate Financial Distress: A Complete Guide to Predicting, Avoiding, and Dealing with Bankruptcy, 2nd ed. (New York: John Wiley & Sons, 1993).

4 The bet was reported in ‘Carl Has 9 Lives but He Is Betting up to 8½’, Business Week, 24 February 1992.

5 However, only less than 20 per cent of all firms (public or private) going through a bankruptcy are successfully reorganized.

6 We are describing the standard events in a bankruptcy reorganization. The general rule is that a reorganization plan will be accepted by the court if all of the creditor classes accept it, and it will be rejected if all of the creditor classes reject it. However, if one or more (but not all) of the classes accept it, the plan may be eligible for a ‘cram down’ procedure. A cram down takes place if the bankruptcy court finds a plan fair and equitable and accepts the plan for all creditors.

7 For example, see S. Gilson, ‘Managing default: some evidence on how firms choose between workouts and bankruptcy’, Journal of Applied Corporate Finance (Summer 1991); and S.C. Gilson, K. John, and L.N.P. Lang, ‘Troubled debt restructuring: an empirical study of private reorganization of firms in defaults’, Journal of Financial Economics, vol. 27 (1990).

8 L.A. Weiss, ‘Bankruptcy dissolution: direct costs and violation of priority and claims’, Journal of Financial Economics, vol. 23 (1990). However, W. Beranek, R. Boehmer and B. Smith, in ‘Much ado about nothing: absolute priority deviations in Chapter 11’, Financial Management (Autumn 1996), find that 33.8 per cent of bankruptcy reorganizations leave shareholders with nothing.

9 S.A. Davydenko and J. Franks, ‘Do bankruptcy codes matter? A study of defaults in France, Germany and the UK’, Journal of Finance, vol. 63 (2008).

10 E.I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993), Chapter 3.

To help you grasp the key concepts of this chapter check out the extra resources posted on the Online Learning Centre at www.mcgraw-hill.co.uk/textbooks/hillier

Among other helpful resources there are PowerPoint presentations, chapter outlines and mini-cases.

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financial distress

Documents

denition of nancial

defaulting rm

valuebased insolvency

nancial structure

required payment

flowbased insolvency

value of assets

financial restructuring