Chapter

30
Financial Distress

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
 Be able to define financial distress and understand
what happens to a firm in distress
 Understand the difference between liquidation and
reorganization
 Understand the absolute priority rule

 Understand the potential benefits of a private workout

versus formal bankruptcy
 Understand the Z-Score Model for predicting
bankruptcy

30-2
Chapter Outline
30.1 What Is Financial Distress?
30.2 What Happens in Financial Distress?
30.3 Bankruptcy Liquidation and Reorganization
30.4 Private Workout or Bankruptcy: Which is
Best?
30.5 Prepackaged Bankruptcy
30.6 Predicting Corporate Bankruptcy: The Z-
Score Model
30-3
30.1 What Is Financial Distress?
 Financial distress is a situation where a firm’s
operating cash flows are not sufficient to
satisfy current obligations, and the firm is
forced to take corrective action.
 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.

30-4
Insolvency
 Stock-base insolvency: the value of the firm’s assets is less than the
value of the debt.

Solvent firm Insolvent firm

Debt Debt
Equity
Assets Assets
Equity Debt

Note the negative equity 30-5

Insolvency
 Flow-base insolvency occurs when the firms cash flows
are insufficient to cover contractually required payments.

Cash flow
shortfall
Contractual
obligations
Firm cash flow

Insolvency time 30-6

 Largest U.S. Bankruptcies
Firm Liabilities Date
(in $ millions)
Lehman Bro. $613,000.00 September 2008

General Motors 172,810.00 June 2009

CIT Group 64,901.20 November 2009

Conseco Inc. 56,639.30 December 2002

Chrysler 55,200.00 April 2009

30-7
30.2 What Happens in Financial
Distress?
 Financial distress does not usually result in the
firm’s death.
 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.
30-8
 What Happens in Financial Distress?
No financial
restructuring
49%

Financial Private
distress workout
47%
51%
Financial Reorganize
restructuring and emerge
83%
53%
Legal bankruptcy 7% Merge with
Chapter 11 another firm

10%
Source: Karen H. Wruck, “Financial Distress: Reorganization and Organizational Efficiency,” Journal of Financial Economics
27 (1990), Figure 2. See also Stuart C. Gilson; Kose John, and Larry N.P. Lang, “Troubled Debt Restructurings: An Empirical
Study of Private Reorganization in Firms in Defaults,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss,
Liquidation
“Bankruptcy Resolution: Direct Costs and Violation of Priority Claims,” Journal of Financial Economics 27 (1990).
30-9
Responses to Financial Distress
 Think of the two sides of the balance sheet.
 Asset Restructuring:
 Selling major assets
 Merging with another firm
 Reducing capital spending and R&D spending
 Financial Restructuring:
 Issuing new securities
 Negotiating with banks and other creditors
 Exchanging debt for equity
 Filing for bankruptcy

30-10
30.3 Bankruptcy Liquidation and
Reorganization
 Firms that cannot meet their obligations have two choices:
liquidation or reorganization.
 Liquidation (Chapter 7) 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 priority.
 Reorganization (Chapter 11) is the option of keeping the firm a
going concern.
 Reorganization sometimes involves issuing new securities to replace
old ones.

30-11
Bankruptcy Liquidation
Straight liquidation under Chapter 7:
1. A petition is filed in a federal court. The debtor firm
could file a voluntary petition or the creditors could file
an involuntary petition against the firm.
2. A trustee-in-bankruptcy is elected by the creditors to
take over the assets of the debtor firm. The trustee will
attempt to liquidate the firm’s assets.
3. After the assets are sold, after payment of the costs of
administration, money is distributed to the creditors.
4. If any money is left over, the shareholders get it.
30-12
Bankruptcy Liquidation: Priority of
Claims
Liquidation proceeds are distributed in order of priority:
1. Administration expenses associated with liquidation
2. Unsecured claims arising after the filing of an involuntary
bankruptcy petition
3. Wages earned within 90 days before the filing date, not to
exceed $2,000 per claimant
4. Contributions to employee benefit plans arising with 180 days
before the filing date
5. Consumer claims, not exceeding $900
6. Tax claims
7. Secured and unsecured creditors’ claims
8. Preferred stockholders’ claims
9. Common stockholders’ claims
30-13
Absolute Priority Rule in Practice
The APR states that senior claims are fully satisfied before junior
claims receive anything.
Deviations from APR
Equityholders Expectation: No payout
Reality: Payout in 81% of cases

Unsecured creditors Expectation: Full payout after

secured creditors
Reality: Violation in 78% of cases

Secured creditors Expectation: Full payout

Reality: Full payout in 92% of
cases 30-14
Reasons for Absolute Priority Rule
Violations
 Creditors want to avoid the expense of litigation.
Debtors are given a 120-day window of opportunity
to cause delay and harm value.
 Managers often own equity and demand to be
compensated. They are in charge for at least the
next 120 days.
 Bankruptcy judges like consensual plans (they do
not clog the court calendar with appeals) and
pressure parties to compromise.

30-15
 Bankruptcy Reorganization: Chapter 11
A typical sequence:
1. A voluntary petition or an involuntary petition is filed.
2. A federal judge either approves or denies the petition.
3. In most cases the debtor continues to run the business.
4. The firm is given 120 days to submit a reorganization plan.
5. Creditors and shareholders are divided into classes. Requires
only approval by 1/2 of creditors owning 2/3 of outstanding
debt.
6. After acceptance by the creditors, the plan is confirmed by the
court.
7. Payments in cash, property, and securities are made to
creditors and shareholders.
30-16
30.4 Private Workout or Bankruptcy:
Which Is Best?
 Both formal bankruptcy and private workouts
involve exchanging new financial claims for old
financial claims.
 Usually, senior debt is replaced with junior debt, and
debt is replaced with equity.
 When they work, private workouts are better than a
formal bankruptcy.
 Complex capital structures and lack of information
make private workouts less likely.

30-17
Private Workout or Bankruptcy: Which
Is Best?
 Advantages of Bankruptcy
1. New credit is available - "debtor in possession" debt
2. Discontinued accrual of interest on pre-bankruptcy unsecured
debt
3. An automatic stay provision
4. Tax advantages
5. Requires only approval by 1/2 of creditors owning 2/3 of
outstanding debt
 Disadvantages of Bankruptcy
1. A long and expensive process
2. Judges are required to approve major business decisions
3. Distraction to management
4. “Hold out” by stockholders

30-18
30.5 Prepackaged Bankruptcy
 Prepackaged Bankruptcy is a combination of a private
workout and legal bankruptcy.
 The firm and most of its creditors agree to private
reorganization outside the formal bankruptcy.
 After the private reorganization is put together
(prepackaged) the firm files a formal bankruptcy (under
Chapter 11).
 The main benefit is that it forces holdouts to accept a
bankruptcy reorganization.
 Offers many of the advantages of a formal bankruptcy, but is
more efficient.

30-19
The Z-Score Model: Public, Manufacturers
 Credit scoring models provide a quick,
objective way to evaluate creditworthiness.
Altman’s Z-Score = 3.3*(EBIT/Total Assets) +
1.2*(NWC/Total Assets) + 1.0*(Sales/Total
Assets) + .6*(MV Equity / BV Debt) + 1.4*
(Accumulated RE / Total Assets)
 Z-Score < 1.81 indicates high probability of bankruptcy
 Z-Score between 1.81 and 2.99 is a grey area
 Z-Score > 2.99 indicates a low probability of bankruptcy

30-20
The Z-Score Model: Private, Non-
Manufacturers
Altman’s Z-Score = 6.56*(NWC/Total Assets)
+ 3.26*(Accumulated RE / Total Assets) +
1.05* (EBIT/Total Assets) + 6.72* (BV
Equity / Total Liabilities)
 Z-Score < 1.23 indicates high probability of bankruptcy
 Z-Score between 1.23 and 2.90 is a grey area
 Z-Score > 2.90 indicates a low probability of bankruptcy

30-21
Quick Quiz
 Define financial distress.
 Contrast Chapter 7 versus Chapter 11
bankruptcy.
 Explain the absolute priority rule.

 Discuss why a private workout may be preferred

to formal bankruptcy.
 What key factors are considered in the Z-Score
model for predicting bankruptcy?
30-22