Week 5
Financial Distress

Topics
 What is financial distress?
 Liquidation vs. reorganization
 Meaning and simplified example

 Scoring models – the Altman Z-score

2

What is Financial Distress?
 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.
 Usually the firm is forced to take actions that it would not have taken if it had sufficient cash flow. Insolvency
 Stock-base insolvency; the value of the firm’s assets is less than the value of the debt.

Solvent firm

Insolvent firm

Debt
Assets

Assets
Equity

Note the negative equity

Debt
Equity
Debt

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

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.

Is the firm worth more as a going concern?
 If the firm is worth more if it continues then the creditors can gain more by deferring their claims: reorganization.
 If the firm is worth less if continues then the best option for creditors is to liquidate.
 As long as an agreement can be worked out, creditors will optimally choose liquidation or reorganization.

7

Bankruptcy Liquidation
Straight liquidation usually involves:
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.

Bankruptcy Liquidation: Priority of
Claims
The distribution of the proceeds of liquidation occurs according to the following priority:

1. Administration expenses associated with liquidation. 2. Other expenses arising after the filing of an involuntary bankruptcy petition.
3. Wages, salaries and commissions.
4. Municipal tax claims.
5. Rent.
6. Claims resulting from employee injuries.
7. Unsecured creditors.
8. Preferred shareholders.
9. Common shareholders.

Example
 Suppose the B.O. Drug Co. decides to liquidate.
 Assume that the liquidation value is $2.7 million. Bonds worth $1.5 million are secured by a mortgage on the corporate headquarters building, which is sold for $1 million. $200,000 is used to cover administrative costs and other claims—after paying this, $2.5 million is available to pay creditors. The only problem is that the unpaid debt is $4 million.

Example (continued)
Following our list of priorities, all creditors are paid before shareholders, and the mortgage bondholders are first in line. The trustee proposes the following distribution:
Type of Claim

Prior Claim

Cash Received
Under Liquidation

Mortgage Bonds

$1,500,000

$1,500,000

Subordinated
Debentures

$2,500,000

$1,000,000

Common Stock
Total

$10,000,000
$14,000,000

$
0
$2,500,000

Key issues
 Priority in payment
 Secured vs. unsecured
 Senior vs. junior or subordinated

Bankruptcy Reorganization:
A typical sequence:
1. A voluntary petition can be filed by the corporation or an involuntary petition can be filed by creditors.
2. A federal judge either approves or denies the petition.
3. In most cases the corporation continues to run the business. 4. The firm is