Financial Distress Essay

1489 words - 6 pages

AFM 371 Winter 2008
Chapter 31 - Financial Distress

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Outline

Background
What Happens in Financial Distress?
Bankruptcy Liquidation and Reorganization
Current Issues in Financial Distress
Two Practice Problems From Chapter 16

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Background

Background

as we will see in Chapter 17, financial distress (and its
associated costs) has a potentially large impact on capital
structure decisions by firms
a firm that defaults on a required payment may be forced to
liquidate its assets
however, more often a defaulting firm will restructure
financial restructuring involves replacing old financial claims
with new ones and takes place with either private workouts or
...view middle of the document...

S. Experience
No financial
restructuring
49%

Financial

Private

distress

workout
47%

51%

What Happens in Financial Distress?

Financial

Reorganize

restructuring

and emerge
83%

53%

Legal

7%

bankruptcy

Merge with
another firm

10%

Liquidation

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Bankruptcy Liquidation and Reorganization
in a legal bankruptcy, firms effectively have two options:
liquidation or reorganization
liquidation means termination of the firm as a going concern
involves selling the assets of the firm for salvage value
proceeds are distributed to creditors in order of priority

reorganization is the option of keeping the firm as a going
concern
sometimes involves issuing new securities to replace old ones

liquidation usually involves:
a petition is filed in court (either voluntarily by the firm or the
creditors can file an involuntary petition)
a trustee-in-bankruptcy is elected by the creditors to take over
the assets of the firm and try to liquidate them
after the assets are sold, money is distributed to the creditors
(after administrative expenses are paid)
any remaining money goes to the shareholders
Bankruptcy Liquidation and Reorganization

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Priority of Claims in Liquidation
1
2

3
4
5
6

7
8
9

Administrative expenses associated with liquidation
Other expenses arising after the filing of an involuntary
bankruptcy petition but prior to the appointment of a trustee
Wages, salaries, and commissions
Municipal tax claims
Rent
Claims from employee injuries not covered by workers’
compensation
Unsecured creditors
Preferred shareholders
Common shareholders
note that (i) federal income tax must be paid before any of
the above; (ii) secured creditors receive proceeds from sale of
the securing assets (if the amount is insufficient, they join this
list as unsecured creditors); and (iii) courts have considerable
flexibility to deviate from this list

Bankruptcy Liquidation and Reorganization

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Liquidation Example
consider the example on pp. 887-888 in the text
the liquidation value is assumed to be $2.7 million
bonds worth $1.5 million are secured by a mortgage on a
building, which is sold for $1 million
$200,000 is used to cover administrative costs
a total of $2.5 million is available to pay creditors
the unpaid debt is $4 million
following the priority list, the trustee proposes the following
distribution
Type of Claim
Mortgage bonds
Subordinated debentures
Common stock
Total

Bankruptcy Liquidation and Reorganization

Prior Claim
$1,500,000
$2,500,000
$10,000,000
$14,000,000

Cash Received
Under Liquidation
$1,500,000
$1,000,000
$0
$2,500,000
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Bankruptcy Reorganization: A Typical Sequence
1

A voluntary petition can be filed in court by the firm or an
involuntary petition can be filed by the creditors

2

A federal judge either approves or denies the petition

3

In most cases, the debtor continues to run...

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