financial_distress

8/7/2019 Financial_Distress

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Dr Raju Indukoori

Financial Distress&

Bankruptcy


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Important terms

Financial Distress

Default

Insolvency

Bankruptcy


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Financial Distress?

Tight Cash flows

A situation where a firms operating cash

flows are not sufficient to satisfy currentobligations and the firm is forced to takecorrective action.


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Default

Threat of default

Financial distress may lead a firm to default on

a contract, and it may involve financialrestructuring between the firm, its creditors, andits equity investors.

Default Failure to meet an interest payment, or

Violation of debt agreement


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Insolvency

It is the reflection of a companys strength interms of assets, cash flows, debt and equitycapital

Assets less than debt

Equity becomes negative


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Bankruptcy

Final confirmation of a business failure

Legal term for insolvency

Formal procedure for working out default


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What is IP?

Insolvency / Bankruptcy at individual level

Sole proprietary

Partnership firms


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Top Bankrupt Companies

1 Lehman Brothers Investment Banking

2 Washington Mutual Finance

3 WorldCom Telecom

4 General Motors Automobile

5 Enron Energy Trading

6 Conseco Insurance, Finance

7 Chrysler Automobile8 Thornburg Mortgage Finance

9 Pacific Gas and Electric Power

10 Texaco Energy


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Causes of Business Failure

Economic Factors Industry

Poor location

Weak product

Financial Factors Insufficient capital

Too much debt

Other factors To break union contracts

To hasten liability settlements


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Causes of Business Failure

Economic Factors : 37.1%

Financial Factors : 47.3%

Neglect, disaster and fraud : 15.6%

*Source DNB in USA


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InsolvencyStock-base insolvency; the value of the firms assets is less

than the value of the debt.

Assets

Debt

Equity

Solvent firm

Debt

AssetsEquity

Insolvent firm

Debt

Note the negative equity


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InsolvencyFlow-base insolvency occurs when the firmscash flows are insufficient to covercontractually required payments.

Contractual

obligations

Insolvency

Rs

Firm cash flow

Cash flow

shortfall

time


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Debt

Mark

etValu

eofT

heFirm

Value ofunlevered

firm

PV of interest

tax shields

Costs offinancial distress

Value of levered firm

Optimal amount of debt

Maximum value of firm

Financial Distress


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Issues for Managers

Is it a technical problem or permanent problem ?

Who would bear the losses ?

Liquidate / Continue ?

Should the firm file for bankruptcy, or should it try to useinformal procedures?

Who would control the firm during liquidation orreorganization?


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What Happens in Financial Distress?

Financial distress does not usually result in the firmsdeath.

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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Reorganizeand emerge

Merge withanother firm

Liquidation

83%

10%

7%

What Happens in Financial Distress

Financialdistress

Financialrestructuring

No financialrestructuring

49%

51%

Legal bankruptcy

Privateworkout

47%

53%


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Remedies for Bankruptcy

Reorganization

Liquidation

Merger


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Reorganization - Informal

Restructuring debt through private workout

Extension: postpone interest / principal / both

Composition: Reduce fixed claimReducing interest rate

Accept low principal

Equity exchange


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Reorganization - Formal

Swap of debt to equity

Swap of debt to preferential equity


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Liquidation

Informal : AssignmentAssets are transferred to 3rd party and

settled on pro-rata

More value

Formal Liquidation: Winding up


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Liquidation priorities

Secured loans are the first priority

Secured loans can claim on thecompanies fixed assets

If fixed assets are not sufficient then theycan claim on general creditor distribution


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Secured creditors.

Trustees administrative costs.

Wages due workers within 3 months prior to filing.

Unpaid contributions to employee benefit plans thatshould have been paid within 6 months prior to filing.


(More...)


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Unsecured claims for customer deposits.

Taxes due.

Unfunded pension plan liabilities.

General (unsecured) creditors.

Preferred stockholders.

Common stockholders.



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Problem


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Problem 1

Creditor Claims:Accounts payable $10.0

Notes payable 5.0

Accrued wages 0.3

Federal taxes 0.5

State and local taxes 0.2

First mortgage 3.0

Second mortgage 0.5Subordinated debentures* 4.0

$23.5*Subordinated to notes payable. (More...)


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Proceeds from liquidation:

From current assets $14.0

From fixed assets* 2.5

Total receipts $16.5

* All fixed assets pledged as collateral to mortgage

holders.

Problem 1


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Creditor Claim Distribution UnsatisfiedAccrued wages $0.3 $0.3 $0.0Federal taxes 0.5 0.5 0.0Other taxes 0.2 0.2 0.0First mortgage 3.0 2.5 0.5Second mortgage 0.5 0.0 0.5

$4.5 $3.5 $1.0

Notes: (1) First mortgage receives entire proceeds from sale of

fixed assets, leaving $0 for the second mortgage.

(2) $16.5 - $3.5 = $13.0 remains for distribution to general

creditors.

Solution 1Priority Distribution


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Remaining Initial Final PercentCreditor GC Claim Distrib.a Amountb Received

Accounts payable $10.0 $6.500 $6.500 65.0%

Notes payable 5.0 3.250 5.000 100.0

Accrued wages 0.0 0.300 100.0

Federal taxes 0.0 0.500 100.0

Other taxes 0.0 0.200 100.0

First mortgage 0.5 0.325 2.825 94.2

Second mortgage 0.5 0.325 0.325 65.0

Sub. deb. 4.0 2.600 0.850 21.2

$20.0 $13.000 $16.500

Solution 1General Creditor Distribution (millions of $)

a Pro rata amount = $13/$20 = 0.65.b Includes priority distribution and $1.75 transfer from

subordinated debentures.


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Can we predictCan we predict

bankruptcy?bankruptcy?


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Current Ratio

Debt Ratio

.. ..

. .X

X

X

X

X

X

DiscriminantBoundary

BankruptFirms

SolventFirms

= Solvent

X = Bankrupt


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The discriminant boundary, orThe discriminant boundary, or ZZlineline, statistically separates the, statistically separates the

bankrupt and solvent companies.bankrupt and solvent companies.

One bankrupt company falls on theOne bankrupt company falls on thesolvent (left) side and one solventsolvent (left) side and one solventcompany falls on the bankruptcompany falls on the bankrupt(right) side.(right) side.

(More...)


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Assume the equation for the boundary line isAssume the equation for the boundary line is

Z = -2 + 1.5(Current ratio) - 5.0(DebtZ = -2 + 1.5(Current ratio) - 5.0(Debtratio).ratio).

if Z = -1 to +1, the future of thecompany is uncertain.

If Z > 1, bankruptcy is unlikely

if Z < -1, bankruptcy is likely to

occur.


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ProblemProblem


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Firm XFirm XCR = 4.00CR = 4.00

DR = 0.40DR = 0.40

Which of the following firms islikely to bankruptcy

Firm YCR = 1.50

DR = 0.75

Z = -2 + 1.5(4.0) - 5.0(0.40)

= +2.0

firm is unlikely to gobankrupt.

Z = -2 + 1.5(1.5) - 5.0(0.75)

= -3.5,

firm is likely to go bankrupt.


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Bankruptcy in India

Sick companies report to BIFR

BIFR helps sick companies in reviving

Winding / liquidation happens according toThe Indian Companies Act.


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Bankruptcy in India

Year Numberof Casesreported

Year Numberof CasesReported

1987 311 1999 413

1988 298 2000 330

1989 202 2001 463

1990 151 2002 559

1991 155 2003 430

1992 177 2004 399

1993 152 2005 180

1994 193 2006 118

1995 115 2007 78

1996 97 2008 57

1997 233 2009 64

1998 370

0

100

200

300

400

500

600

1987

1990

1993

1996

1999

2002

2005

2008


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