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    Business Failure

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    Sachin Bassaiye
    This document discusses business failure and bankruptcy. It covers the major causes of business failure, how failure rates fluctuate with the economy, and that smaller firms are more prone to failure. It also describes informal reorganization remedies, key issues managers face in financial distress, US bankruptcy law chapters and terms, differences between informal and formal reorganization, claim priority in Chapter 7 liquidation, and how multiple discriminant analysis can predict bankruptcy.

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    Attribution Non-Commercial (BY-NC)
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    Business Failure

    Uploaded by

    Sachin Bassaiye
    322 views31 pages
    This document discusses business failure and bankruptcy. It covers the major causes of business failure, how failure rates fluctuate with the economy, and that smaller firms are more prone to failure. It also describes informal reorganization remedies, key issues managers face in financial distress, US bankruptcy law chapters and terms, differences between informal and formal reorganization, claim priority in Chapter 7 liquidation, and how multiple discriminant analysis can predict bankruptcy.

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    This document discusses business failure and bankruptcy. It covers the major causes of business failure, how failure rates fluctuate with the economy, and that smaller firms are more prone to failure. It also describes informal reorganization remedies, key issues managers face in financial distress, US bankruptcy law chapters and terms, differences between informal and formal reorganization, claim priority in Chapter 7 liquidation, and how multiple discriminant analysis can predict bankruptcy.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    322 views31 pages

    Business Failure

    Uploaded by

    Sachin Bassaiye
    This document discusses business failure and bankruptcy. It covers the major causes of business failure, how failure rates fluctuate with the economy, and that smaller firms are more prone to failure. It also describes informal reorganization remedies, key issues managers face in financial distress, US bankruptcy law chapters and terms, differences between informal and formal reorganization, claim priority in Chapter 7 liquidation, and how multiple discriminant analysis can predict bankruptcy.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 31

    |  

    Bankruptcy, Reorganization,
    and Liquidation

    „ Financial distress process


    „ Federal bankruptcy law
    „ Reorganization
    „ Liquidation
    |  |

    What are the major causes


    of business failure?
    „aconomic factors
    ¦industry weakness
    ¦poor location/product
    „Financial factors
    ¦too much debt
    ¦insufficient capital
    Most failures occur because a
    number of factors combine to make
    the business unsustainable.
    |  

    Do business failures occur evenly


    over time?

    „ u large number of businesses fail


    each year, but the number in any one
    year has never been a large
    percentage of the total business
    population.
    „ The failure rate of businesses has
    tended to fluctuate with the state of
    the economy.
    | 

    What size firm, large or small, is more


    prone to business failure?

    „ Bankruptcy is more frequent among


    smaller firms.
    „ Large firms tend to get more help
    from external sources to avoid
    bankruptcy, given their greater
    impact on the economy.
    |  

    What key issues must managers


    face in the financial distress process?

    „ ÿs it a temporary problem (technical


    insolvency) or a permanent problem
    caused by asset values below debt
    obligations (insolvency in
    bankruptcy)?
    „ Who should bear the losses?
    „ Would the firm be more valuable if it
    continued to operate or if it were
    liquidated? (More...)
    |  

    „ [hould the firm file for bankruptcy,


    or should it try to use informal
    procedures?
    „ Who would control the firm during
    liquidation or reorganization?
    |  

    What informal remedies are available


    to firms in financial distress?

    „ ÿnformal reorganization
    „ ÿnformal liquidation
    „ Why might informal remedies be
    preferable to formal bankruptcy?
    „ What types of companies are most
    suitable for informal remedies?
    |  

    ÿnformal Bankruptcy Terminology

    „ Workout: Voluntary informal


    reorganization plan.
    „ Restructuring: Current debt terms
    are revised to facilitate the firm¶s
    ability to pay.
    ¦axtension: Creditors postpone the
    dates of required interest or principal
    payments, or both. Creditors prefer
    extension because they are promised
    eventual payment in full. (More...)
    | 

    ¦Composition: Creditors voluntarily


    reduce their fixed claims on the debtor
    by either accepting a lower principal
    amount or accepting equity in lieu of
    debt repayment.
    „ ussignment: un informal procedure
    for liquidating a firm¶s assets. Title
    to the debtor¶s assets is transferred
    to a third party, called a trustee or
    assignee, and then the assets are
    sold off.
    |  

    Describe the following terms related to


    U.[. bankruptcy law:
    „ Chapter 11: Business reorganization
    guidelines.
    „ Chapter 7: Liquidation procedures.
    „ Trustee:
    ¦ uppointed to control the company when
    current management is incompetent or
    fraud is suspected.
    ¦Used only in unusual circumstances.
    (More...)
    |  

    „ Voluntary bankruptcy: u
    bankruptcy petition filed in
    federal court by the distressed
    firm¶s management.
    „ ÿnvoluntary bankruptcy: u
    bankruptcy petition filed in
    federal court by the distressed
    firm¶s creditors.
    |  |

    What are the major differences


    between an informal reorganization
    and reorganization in bankruptcy?

    „ ÿnformal Reorganization:
    ¦Less costly
    ¦Relatively simple to create
    ¦Typically allows creditors to recover
    more money and sooner.
    (More...)
    |  

    „ Reorganization in Bankruptcy
    ¦uvoids holdout problems.
    ¦Due to automatic stay provision,
    avoids common pool problem.
    ¦ÿnterest and principal payments
    may be delayed without penalty
    until reorganization plan is
    approved.
    (More...)
    |  

    ¦Aermits the firm to issue debtor in


    possession (DÿA) financing.
    ¦Gives debtor exclusive right to
    submit a proposed reorganization
    plan for agreement from the parties
    involved.
    ¦Reduces fraudulent conveyance
    problem.
    ¦Cramdown if majority in each
    creditor class approve plan.
    |  

    What is a prepackaged bankruptcy?

    „ oew type of reorganization


    ¦Combines the advantages of both formal
    and informal reorganizations.
    ¦uvoids holdout problems
    ¦Areserves creditors¶ claims
    ¦Favorable tax treatment.
    „ ugreement to plan obtained from
    creditors prior to filing for bankruptcy.
    „ Alan filed with bankruptcy petition.
    |  

    List the priority of claims in a


    Chapter 7 liquidation.

    „ [ecured creditors.
    „ Trustee¶s administrative costs.
    „ axpenses incurred after involuntary
    case begun but before trustee
    appointed.
    „ Wages due workers within 3 months
    prior to filing. (More...)
    |  

    „ Unpaid contributions to employee


    benefit plans that should have been
    paid within 6 months prior to filing.
    „ Unsecured claims for customer
    deposits.
    „ Taxes due.
    „ Unfunded pension plan liabilities.
    „ General (unsecured) creditors.
    „ Areferred stockholders.
    „ Common stockholders.
    |  

    Liquidation ÿllustration Data


    (millions of $)
    Creditor Claims:
    uccounts payable $10.0
    ootes payable 5.0
    uccrued wages 0.3
    Federal taxes 0.5
    [tate and local taxes 0.2
    First mortgage 3.0
    [econd mortgage 0.5
    [ubordinated debentures* 4.0
    $23.5
    *[ubordinated to notes payable.
    (More...)
    |  

    Aroceeds from liquidation:


    From current assets $14.0
    From fixed assets* 2.5
    Total receipts $16.5

    * ull fixed assets pledged as collateral to mortgage


    holders.
    |  |

    Ariority Distribution
    (millions of $)
    Creditor Claim Distribution Unsatisfied
    uccrued 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
    [econd mortgage 0.5 0.0 0.5
    $4.5 $3.5 $1.0

    ootes: (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.
    |  |

    General Creditor Distribution (millions of $)


    Remaining ÿnitial Final Aercent
    Creditor GC Claim Distrib.a umountb Received
    uccounts payable $10.0 $6.500 $6.500 65.0%
    ootes payable 5.0 3.250 5.000 100.0
    uccrued 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
    [econd mortgage 0.5 0.325 0.325 65.0
    [ub. deb. 4.0 2.600 0.850 21.2
    $20.0 $13.000 $16.500
    a Aro rata amount = $13/$20 = 0.65.
    b ÿncludes priority distribution and $1.75 transfer from
    subordinated debentures.
    |  ||

    Other Motivations for Bankruptcy

    „ oormally, bankruptcy is motivated by


    serious current financial problems.
    „ However, some companies have used
    bankruptcy proceedings for other
    purposes:
    ¦To break union contracts
    ¦To hasten liability settlements
    |  |

    [ome Criticisms of Bankruptcy Laws

    „ Critics contend that current (1978)


    bankruptcy laws are flawed.
    „ Too much value is siphoned off by
    lawyers, managers, and trustees.
    „ Companies that have no hope remain
    alive too long, leaving little for
    creditors when liquidation does occur.
    „ Companies in bankruptcy can hurt
    other companies in industry.
    |  |

    Chapter 24 axtension

    „ MDu to predict bankruptcy


    „ Recent business failures
    |  |
    What is MDu, and how can it be used
    to predict bankruptcy?

    „ Multiple discriminant analysis (MDu)


    is a statistical technique similar to
    multiple regression.
    „ ÿt identifies the characteristics of
    firms that went bankrupt in the past.
    „ Then, data from any firm can be
    entered into the model to assess the
    likelihood of future bankruptcy.
    |  |

    MDu ÿllustration

    „ ussume you have the following 2003


    data for 12 companies:
    ¦Current ratio
    ¦Debt ratio
    „ [ix of the companies (marked by Xs)
    went bankrupt in 2004 while six
    (marked by dots) remained solvent.
    (More...)
    |  |

    Current Ratio Discriminant

    . . Boundary

    [olvent
    Firms
    . .
    X

    . . X

    X
    X
    X
    X Bankrupt
    Firms

    . = [olvent
    X = Bankrupt
    Debt Ratio

    (More...)
    |  |

    „ The discriminant boundary, or Z line,


    statistically separates the bankrupt
    and solvent companies.
    „ oote that two companies have been
    misclassified by the MDu program:
    One bankrupt company falls on the
    solvent (left) side and one solvent
    company falls on the bankrupt (right)
    side.
    (More...)
    |  |

    „ ussume the equation for the


    boundary line is
    Z = -2 + 1.5(Current ratio) - 5.0(Debt ratio).

    „ Furthermore, if Z = -1 to +1, the future


    of the company is uncertain. ÿf Z > 1,
    bankruptcy is unlikely; if Z < -1,
    bankruptcy is likely to occur.
    |  

    Using MDu To Aredict Bankruptcy

    „ [uppose Firm [ has CR = 4.0 and


    DR = 0.40. Then,
    Z = -2 + 1.5(4.0) - 5.0(0.40) = +2.0,
    and firm is unlikely to go bankrupt.
    „ [uppose Firm B has CR = 1.5 and
    DR = 0.75. Then,
    Z = -2 + 1.5(1.5) - 5.0(0.75) = -3.5,
    and firm is likely to go bankrupt.
    |  

    [ome Final Aoints

    „ The most well-known bankruptcy


    prediction model is adward ultman¶s
    five factor model.
    „ [uch models tend to work relatively
    well, but only for the near term.
    „ The more similar the historical sample
    to the firm being evaluated, the better
    the prediction.

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