Financial Distress

&
Bankruptcy

Dr Raju Indukoori
 Important terms
• Financial Distress

• Default

• Insolvency

• Bankruptcy

Dr Raju Indukoori
 Financial Distress?
Tight Cash flows
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.

Dr Raju Indukoori
 Default

Threat of default
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.

Default
• Failure to meet an interest payment, or
• Violation of debt agreement
Dr Raju Indukoori
 Insolvency
It is the reflection of a company’s strength in
terms of assets, cash flows, debt and equity
capital

• Assets less than debt

• Equity becomes negative

Dr Raju Indukoori
 Bankruptcy
• Final confirmation of a business failure

• Legal term for insolvency

• Formal procedure for working out default

Dr Raju Indukoori
 What is IP?

Insolvency / Bankruptcy at individual level

• Sole proprietary

• Partnership firms

Dr Raju Indukoori
 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 Automobile
8 Thornburg Mortgage Finance
9 Pacific Gas and Electric Power
10 Texaco Energy
Dr Raju Indukoori
 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

Dr Raju Indukoori
 Causes of Business Failure
• Economic Factors : 37.1%

• Financial Factors : 47.3%

• Neglect, disaster and fraud : 15.6%

*Source DNB in USA

Dr Raju Indukoori
 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
Debt
Equity

Note the negative equity

Dr Raju Indukoori
 Insolvency
Flow-base insolvency occurs when the firms
cash flows are insufficient to cover
contractually required payments.
Rs

Cash flow
shortfall
Contractual
obligations
Firm cash flow

Insolvency time
Dr Raju Indukoori
 Financial Distress
Maximum value of firm

Costs of
Market Value of The Firm

financial distress

PV of interest
tax shields
Value of levered firm

Value of
unlevered
firm

Optimal amount of debt

Debt
Dr Raju Indukoori
 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 use

informal procedures?

• Who would control the firm during liquidation or

reorganization?
Dr Raju Indukoori
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.
Dr Raju Indukoori
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
another firm

10%
Liquidation
Dr Raju Indukoori
Remedies for Bankruptcy

 Reorganization

 Liquidation

 Merger

Dr Raju Indukoori
Reorganization - Informal

Restructuring debt through private workout

• Extension: postpone interest / principal / both
• Composition: Reduce fixed claim
 Reducing interest rate
 Accept low principal

 Equity exchange

Dr Raju Indukoori
Reorganization - Formal

• Swap of debt to equity

• Swap of debt to preferential equity

Dr Raju Indukoori
Liquidation

 Informal : Assignment
 Assets are transferred to 3rd party and
settled on pro-rata
 More value

 Formal Liquidation: Winding up

Dr Raju Indukoori
Liquidation priorities

 Secured loans are the first priority

 Securedloans can claim on the

companies fixed assets

 Iffixed assets are not sufficient then they

can claim on general creditor distribution

Dr Raju Indukoori
Liquidation priorities
 Secured creditors.

 Trustee’s administrative costs.

 Wages due workers within 3 months prior to filing.

 Unpaid contributions to employee benefit plans that

should have been paid within 6 months prior to filing.

(More...)
Dr Raju Indukoori
Liquidation priorities

 Unsecured claims for customer deposits.

 Taxes due.

 Unfunded pension plan liabilities.

 General (unsecured) creditors.

 Preferred stockholders.

 Common stockholders.

Dr Raju Indukoori
Problem

Dr Raju Indukoori
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 0.5
Subordinated debentures* 4.0
$23.5
*Subordinated to notes payable. (More...)
Dr Raju Indukoori
Problem 1

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.

Dr Raju Indukoori
Solution 1
Priority Distribution

Creditor Claim Distribution Unsatisfied

Accrued wages $0.3 $0.3 $0.0
Federal taxes 0.5 0.5 0.0
Other taxes 0.2 0.2 0.0
First mortgage 3.0 2.5 0.5
Second 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.
Dr Raju Indukoori
Solution 1
General Creditor Distribution (millions of $)
Remaining Initial Final Percent
Creditor 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
a
Pro rata amount = $13/$20 = 0.65.
b
Includes priority distribution and $1.75 transfer from
subordinated debentures.
Dr Raju Indukoori
Can we predict
bankruptcy?

Dr Raju Indukoori
 Predicting Bankruptcy

 Assume you have the following data

for 12 companies:
– Current ratio
– Debt ratio

 Six
of the companies (marked by Xs)
went bankrupt in 2004 while six
(marked by dots) remained solvent.
(More...)
Dr Raju Indukoori
Current Ratio Discriminant

. . Boundary

Solvent
Firms
. .
X

. . X

X
X
X
X Bankrupt
Firms

.
X = Bankrupt
= Solvent
Debt Ratio
Dr Raju Indukoori
 The discriminant boundary, or Z
line, statistically separates the
bankrupt and solvent companies.

 One bankrupt company falls on the

solvent (left) side and one solvent
company falls on the bankrupt
(right) side.
(More...)
Dr Raju Indukoori
Assume the equation for the boundary line is
Z = -2 + 1.5(Current ratio) - 5.0(Debt
ratio).

• if Z = -1 to +1, the future of the

company is uncertain.

• If Z > 1, bankruptcy is unlikely

• if Z < -1, bankruptcy is likely to

occur. Dr Raju Indukoori
Problem

Dr Raju Indukoori
 Which of the following firms is
likely to bankruptcy
Firm X Firm Y
CR = 4.00 CR = 1.50
DR = 0.40 DR = 0.75

Z = -2 + 1.5(4.0) - 5.0(0.40) Z = -2 + 1.5(1.5) - 5.0(0.75)

= +2.0
= -3.5,
firm is unlikely to go
bankrupt. firm is likely to go bankrupt.

Dr Raju Indukoori
 Bankruptcy in India

 Sick companies report to BIFR

 BIFR helps sick companies in reviving

 Winding/ liquidation happens according to

The Indian Companies Act.

Dr Raju Indukoori
 Bankruptcy in India
Year Number Year Number 600
of Cases of Cases
reported Reported
500
1987 311 1999 413
400
1988 298 2000 330
1989 202 2001 463 300

1990 151 2002 559

200
1991 155 2003 430
1992 177 2004 399 100

1993 152 2005 180

0
1994 193 2006 118 87

90

93

96

99

02

05

08
19

19

19

19

19

20

20

20
1995 115 2007 78
1996 97 2008 57
1997 233 2009 64
1998 370 Dr Raju Indukoori
Thank You
Questions???

Dr Raju Indukoori