Ch30:What Is Financial Distress?

The text defines financial distress as: "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." The most important point is that the firm is forced to take actions that it would not otherwise choose. Insolvency: Stock-based insolvency occurs when the value of assets is less than the value of promised payments to debt.Flow-based insolvency occurs when operating cash flows are insufficient to cover contractually required payments. Flow-based insolvency typically results in more immediate actions, and often leads to bankruptcy. Stock-based insolvency is commonly regarded as a signal of financial distress. For example, during the S&L crisis many U.S. banks and S&L's were solvent in terms of cash flow but were stock-based insolvent, i.e., asset values were below liability values. Current accounting and regulatory practices allow S&L's to continue operating despite stock-based insolvency. Stock-based insolvent S&L's often are not reorganized by the Resolution Trust Corporation (RTC) until they face a flow-based crisis. The RTC is the federal agency charged with reorganizing the assets and liabilities of insolvent financial institutions. What Happens in Financial Distress?Financial distress can serve as the firm's "early warning" signal. Ironically, firms with high financial leverage often face financial distress earlier and, therefore, have more time to reorganize. Firms with low leverage may not recognize they are in distress until too late. Responses to Financial Distress: A firm can respond to financial distress by increasing available cash flows (asset restructuring) or by reducing liabilities (financial restructuring). Low leverage firms have very limited options in financial restructuring, and, due to delay in their response, the asset values have often deteriorated. For these reasons, firms with low financial leverage are more likely to liquidate than firms with high leverage. Asset Restructuring: Selling major assets:When Chrysler Corporation was in distress in 1980, it sold its 'Crown Jewel' its highly profitable division that produced tanks for the U.S. military.Merging with another firm, Reducing capital spending and R&D spending:Reduced capital spending makes sense if the foregone projects have negative NPV, perhaps due to a rise in the cost of capital in the presence of bankruptcy risk. However, if reduced investment is in response to "Selfish strategy #2: Incentive to underinvest" from an earlier chapter, then the firm may be foregoing positive-NPV projects. In this case, it is not following an optimal investment strategy. Financial Restructuring: Issuing new securities, Negotiating with banks and other creditors, Exchanging equity for debt, Filing for bankruptcy.Bankruptcy Liquidation and Reorganization: The Federal Bankruptcy Reform Act of 1978 (as amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005) provides for two forms of formal bankruptcy: (1) a bankruptcy liquidation under Chapter 7 of the code and (2) a bankruptcy reorganization under Chapter 11. Creditors will prefer Chapter 7 when the liquidation value of the firm is larger than the value of the firm as a going concern. A)Bankruptcy Liquidation chapter 7. An involuntary bankruptcy liquidation petition may be filed by creditors if both of the following conditions are met: 1)The corporation is not paying debts as they come due. 2)If there are more than 12 creditors, at least three with claims totaling $500 or more must join in the filing. If there are fewer than 12 creditors, then only one with a claim of $500 is required to file. Bankruptcy Liquidation: Priority of Claims

The absolute priority rule (APR) determines priority of claim in bankruptcy liquidation and reorganization. The rule states that senior claims must be fully satisfied before junior claims are serviced. Exceptions to the APR are possible such as a mortgage secured by real estate property. B)Bankruptcy Reorganization chapter 11: petitions can be filed by the corporation or by its creditors. In a Chapter 11 reorganization, the bankruptcy judge has responsibility for major business decisions, although management input and cooperation is essential to a smooth reorganization. Private Workout or Bankruptcy: Which Is Best? In order to avoid the costs and delays of formal bankruptcy, firms can try to negotiate a private workout with creditors. If creditors cooperate in a private workout and forego a part of their original claim, they are betting that their ultimate payoff will be higher than if the firm were to be dragged through the bankruptcy courts. Gilson [1989] estimates that only 30% of senior managers (CEO, chairman, and president) survive the four-year period starting two years prior to a Chapter 11 bankruptcy filing. The survival rate of senior management in private workouts was only slightly higher at 40%. Advantages of Formal Bankruptcy versus Private Workout: 1.Formal bankruptcy allows firms to issue new debt ("debtor in possession" or "DIP" debt) that is senior to all previously issued debt. This new senior debt can provide enough cash for the firm to continue to conduct its business. 2.Interest on pre-bankruptcy unsecured debt stops accruing after formal bankruptcy is recognized. 3.An automatic stay provision protects the firm from its creditors during bankruptcy proceedings. 4.There are tax advantages to formal bankruptcy relative to private workouts. 5. While a private workout requires acceptance of the plan by all creditors, formal bankruptcy requires acceptance of the plan by one-half of creditors owning 2/3 of outstanding claims. Disadvantages of Formal Bankruptcy versus Private Workout:1. Legal and professional fees have top priority according to the absolute priority rule. Because legal fees accrue on an hourly basis, lawyers and investment bankers have little reason to work toward a rapid reorganization of the firm. 2. In a bankruptcy reorganization through Chapter 11, judges are required to approve all major business decisions. All stakeholders can be adversely affected if judges make financing and investment decisions that are not based on maximizing firm value. Lost investment opportunities represent one form of opportunity costs in bankruptcy proceedings. 3. Similarly, if managers' attention is diverted by the bankruptcy proceedings, they may not pursue all positive-NPV investment opportunities. 4. Stockholders may be able to hold out for a better deal in Chapter 11 bankruptcy than in a private workout because interest on pre-bankruptcy debt has stopped accruing and the availability of "debtor in possession" debt. C)The Marginal Firm: There are two potentially important tax advantages to Chapter 11 bankruptcy over a private workout. First, in a private workout, tax loss carry forwards are forfeit if the ownership claim of original shareholders is diluted to less than 50% of the firm. Second, if debt is exchanged for less than its original face value, the reduction of face value is taxed as if it were income, despite the fact that it is in recognition of a real economic loss. If the firm goes through Chapter 11 bankruptcy, the tax liability related to "cancellation of indebtedness" is forgiven. D)Holdouts: Bondholders also can have an incentive to resist private workouts and hold out for a larger payoff. The problem of bondholder holdouts became the focal point in January 1990 during bankruptcy rulings on LTV Corporation. Prior to filing for bankruptcy in 1986, LTV arranged a private workout in which some bondholders voluntarily received bonds with market values well below the face value of their original bonds. When LTV finally went through Chapter 11, the court ruled that bondholders participating in the swap had given up their claim to their original face value. Bondholders not participating in the swap retained their original claim on the firm. Consequently, bondholders that "held out" were rewarded with a larger payoff during bankruptcy proceedings. A prepackaged bankruptcy could have forced all bondholders to participate on a pro rata basis and preserved the relative claims of all participants. E) Complexity: A firm with a complicated capital structure will have difficulty constructing a private workout. F)Lack of Information: A greater degree of information asymmetry (particularly between managers, bondholders, and equity holders) will make it more difficult to complete a private workout. Prepackaged Bankruptcy: By negotiating with creditors prior to a formal bankruptcy filing, corporations can combine the best characteristics of private workouts and formal bankruptcy. McConnell and Servaes [1991] view prepackaged bankruptcies as an administrative extension of an informal reorganization, with the following advantages:1.Because only one-half of creditors holding at least two-thirds of the firm's liabilities are needed for approval of a bankruptcy plan, holdouts can be reduced. 2.In addition to reducing holdout disputes, prepackaged bankruptcies can capture all of the advantages of formal bankruptcy (including tax advantages) while minimizing the disadvantages. prepackaged bankruptcy is usually cheaper and faster than a traditional bankruptcy. By agreeing to a prepackaged bankruptcy, existing debtholders can preserve their priority of claim and avoid a possible reduction in value from the use of new "debtor in possession" (DIP) debt. The Z-Score Model: Public, Manufacturers: Credit scoring models provide a quick, objective way to assess the creditworthiness of prospective borrowers by assessing factors that have historically been associated with the risk of default. Altmans Z score is found using the following equation: Z = 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) A Z-score less than 2.675 is indicative of a high probability (95%) of declaring bankruptcy within the next year. However, 1.81 to 2.99 is really a grey area, with the critical high and low probabilities of bankruptcy being below 1.81 and above 2.99, respectively. The Z-Score Model: Private, Non-Manufacturers: The above model requires a firm to have publicly traded equity and be a manufacturer. A revised model can be used on private firms and non-manufacturing companies: Z = 6.56*(NWC/Total Assets) + 3.26*(Accumulated RE / Total Assets) + 1.05*(EBIT/Total Assets) + 6.72*(BV Equity / Total Liabilities) The critical levels for this model are 1.23 and 2.90, respectively. Q: Financial distress frequently can serve as a firms early warning sign for trouble. Thus, it can be beneficial since it may bring about new organizational forms and new
operating strategies. Just because a firm is experiencing financial distress doesnt necessarily imply the firm is worth more dead than alive. APR: administrative expenses, unsecured claims after a filing of involuntary bankruptcy petition, wages, employee benefit plans, consumer claims, taxes, secured and unsecured loans, preferred stocks and common stocks. DIP (debtor in possession) : Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt.

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Ch 25: A futures contract is like a forward contract: It specifies that a certain commodity will be exchanged at a specified time in the future at a price specified today. A futures contract is different from a forward: Futures are standardized contracts trading on organized exchanges with daily resettlement (marking to market) through a clearinghouse. Standardizing Features: Contract Size, Delivery Month. Daily resettlement Minimizes the chance of default. Initial Margin: A margin is cash or marketable securities deposited by an investor with his or her broker. The balance in the margin account is adjusted to reflect daily settlement. Normally, initial margin is 4% of the contract value. Hedging: Use derivative tools to reduce the risk that they face from potential future movements in a market variable. Speculating: Use derivative tools to bet on the future direction of a market variable. Duration Hedging: As an alternative to hedging with futures or forwards, one can hedge by matching the interest rate risk of assets with the interest rate risk of liabilities.Duration is the key to measuring interest rate risk. Duration: This P leads to = Dr The percentage change in a bond price is approximately equal to its duration multiplied by the size of the parallel P curve. Duration measures the combined effect of maturity, coupon rate, and YTM on a bonds price sensitivity to interest rates. shift in the yield Measure of the bonds effective maturity Weighted average maturity of the bonds cash flows. Properties: Longer maturity, longer duration, Higher coupon, shorter duration, Higher yield, shorter duration. Zero coupon bond: duration = maturity. Ch 29:The Basic Forms of Acquisitions: Merger or Consolidation, Acquisition of Stock, Acquisition of Assets. Merger: One firm is acquired by another. Acquiring firm retains name and acquired firm ceases to exist. Consolidation: Entirely new firm is created from combination of existing firms. Advantage: legally simple. Disadvantage: must be approved by a majority vote of the shareholders of both firms. Tender offer offer by one firm or individual to buy shares in another firm. No shareholder vote is required for a tender offer.Synergy: V = VAB (VA + VB). Synergy the value of the whole exceeds the sum of the parts. Sources of Synergy: CF = Revenue - Costs - Taxes - Capital Requirements. Revenue Enhancement: Reduction in competition or increase in market share, Acquisitions that allow a firm to enter a new industry that may become a platform for further expansion. Cost Reduction: Replacement of ineffective managers, Economy of scale or scope. Tax Gains: Net operating losses. a firm with losses may be attractive to a firm with significant tax liabilities. Unused debt capacity: Incremental new investment required in working capital and fixed assets. The synergy of an acquisition can be determined from the standard discounted cash flow model: The value of Firm B to Firm A = VB * = V + VB. VB * will be greater than VB if the acquisition produces positive incremental cash flows, CF. Two Bad Reasons for Mergers: 1. Earnings Growth: If there are no synergies or other benefits to the merger, then the growth in EPS is just an artifact of a larger firm and is not true growth (i.e., an accounting illusion). In this case, the P/E ratio should fall because the combined market value should not change. 2. Diversification: A firms attempt at diversification does not create value because stockholders could buy the stock of both firms, probably more cheaply. Firms cannot reduce their systematic risk by merging. A Cost to Stockholders from Reduction in Risk: The Base Case: If two all-equity firms merge, there is no transfer of synergies to bondholders, but if Both Firms Have Debt: The coinsurance effect transfers value from stockholders to bondholders. How Can Shareholders Reduce their Losses from the Coinsurance Effect? Retire debt premerger and/or increase post-merger debt usage. Cash Acquisition: The NPV of a cash acquisition is: NPV = (VB + V) cash cost = VB* cash cost. Value of the combined firm is: VAB = VA + (VB* cash cost) Merger premium: amount paid above the stand-alone value. Stock Acquisition: Value of combined firm VAB = VA + VB + V. Cost of acquisition: Depends on the number of shares given to the target stockholders. Depends on the price of the combined firms stock after the merger. Considerations when choosing between cash and stock: Sharing gains target stockholders do not participate in stock price appreciation with a cash acquisition. Taxes cash acquisitions are generally taxable. Control cash acquisitions do not dilute control. Going Private and Leveraged Buyouts: The existing management buys the firm from the shareholders and takes it private. If it is financed with a lot of debt, it is a leveraged buyout (LBO). The extra debt provides a tax deduction for the new owners, while at the same time turning the pervious managers into owners. This reduces the agency costs of equity. ***Cost of acquiring firm A to firm B: (# shares offered/total # of new shares) *VAB. how many shares shud firm B receive? (Cost we want on acquisition/VAB)=X(firmA # of shares+X) Ch22: Delta: This practice of the construction of a riskless hedge is called delta hedging. The delta of a call option is positive. The Black-Scholes:The Black-Scholes Model allows
us to value options in the real world just as we have done in the 2-state world. Stocks and Bonds as Options: Levered equity is a call option: The underlying asset comprises the assets of the firm, The strike price is the payoff of the bond. If at the maturity of their debt, the assets of the firm are greater in value than the debt, the shareholders have an in-the-money call. They will pay the bondholders and call in the assets of the firm. If at the maturity of the debt the shareholders have an out-of-the-money call, they will not pay the bondholders (i.e. the shareholders will declare bankruptcy) and let the call expire. Levered equity is a put option: The underlying asset comprises the assets of the firm.The strike price is the payoff of the bond. If at the maturity of their debt, the assets of the firm are less in value than the debt, shareholders have an in-the-money put.They will put the firm to the bondholders. If at the maturity of the debt the shareholders have an out-of-the-money put, they will not exercise the option (i.e. NOT declare bankruptcy) and let the put expire.

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