Introduction
The economic impact of bankruptcy and reorganization can be studied using capital structure. The main objective of studies, which use capital structure, is to analyze the gains or losses to the capital following reorganization. A number of studies that utilized capital structure data in order to evaluate whether reorganization created value has been documented. The majority of the studies show that the value of shareholders decreased following a reorganization. Harold (2001) found out that can be reorganized after reduced profits in the preceding periods.
Brealey, Myers and Marcus (2007) stated that bankruptcy occurs when a company is unable to pay its short-term and long-term liabilities. While reorganization is a result of bankruptcy process that was initiated by a creditor. All creditors and stockholders, including dissenters, are bound by the organization plan (Harold, 1999).
Harold (1999) stated that reorganization plan should be fair, equitable, and feasible. This means that all parties must be treated fairly and equitably and that the plan must be workable with respect to the earnings power and financial structure of the reorganized company as well as the ability of the company to obtain trade credit and, perhaps, short-term bank loans.
Brealey, Myers and Marcus (2007) found that a company value for reorganization could be evaluated to using liquidity and capital structure. In the event that the company has failed to meet its legal obligations but there future opportunities look bright, reorganization becomes the best option.
Whenever a debtor enters into a voluntary settlement resulting in the assignment of assets or the appointment of a trustee, the company has committed an act of bankruptcy. The procedures for the reorganization of a corporation that has become bankrupt, either voluntarily or involuntarily are quite a difficult to implement. In the reorganization process, there are certain standard procedures that must be employed in order to provide an acceptable solution. The procedures for the initiation and execution of corporate reorganizations, which include filing, the appointment of a trustee, the development of reorganization plan, the approval of the plan, and the payment of expenses.
Literature review
The trustee recommends Brealey, Myers and Marcus (2007) states reorganization of the firm; he must draw up a plan. Reorganization plan is generally concerned with the firm’s capital structure. Since most firms’ financial difficulties result from high fixed charges, the capital structure is generally altered in order to reduce the fixed charges. Debts are exchanged for equity or the maturities of debts are extended. Sometimes income bonds are exchanged for debentures and mortgage bonds. An income bond requires the payment of interest only when sufficient earnings are available to pay it. The trustee, in recapitalizing the firm, places a great deal of emphasis on building a mix of debt and equity that allows owners. It is important to recognize that it is the valuation of owner returns after the recapitalization that is one of the bases for the reorganization decision.
Reorganization procedures
According to Brealey, Myers and Marcus (2007) the procedures for the reorganization of a corporation that has become bankrupt, either voluntarily or involuntarily are quite easily implemented. In the reorganization process, there are certain standard procedures that must be employed in order to provide an acceptable solution. The procedures for the initiation and execution of corporate reorganizations involves five separate steps – filing, the appointment of a trustee, the development of a reorganization plan, the approval of the plan, and the payment of expenses.
- Filing: A reorganization petition must be filed in a court. An arrangement here is a special type of reorganization in which the management of the firm may be placed in the hands of a receiver or left in the hands of the existing management. The debtor proposes an arrangement, or a plan, by which it will discharge its creditors’ claims. The plan must be accepted by all the creditors, and the court must judge the reasonableness of the arrangement in light of the creditors’ interests.
- The appointment of a trustee: The judge before whom the reorganization petition is submitted will evaluate it and, if he finds it in order, enter an order-approving debtor to remain in possession of the assets. If the debtor’s liabilities exceed some amount, the judge is required to appoint a trustee. Since the duties of the trustee are of importance, they will be discussed in a separate section.
- The reorganization plan: The trustee, after investigating the firm’s situation, submits a plan of reorganization to the court. The plan is filed and a hearing is held to determine whether it should be approved. The main requirement is that the plan be fair, equitable, and feasible. The court’s approval or disapproval is based on its evaluation of the plan in light of these standards.
Fair and equitable means a plan is considered fair and equitable if it maintains the priorities of the respective contractual rights of the creditors, preferred stockholders, and common stockholders. It would also be unfair to eliminate the original common stockholders as owners if the valuation of the firm indicates that some equity still exists.
By Feasible, means that plan must be workable. The reorganized corporation must have sufficient working capital, sufficient funds to cover fixed charges, sufficient credit prospects, and a sufficient ability to service debt to retire or refund debts as proposed by the plan. This requirement is intended to ensure that the reorganized firm can operate efficiently, compete with other companies in the industry, and avoid a future reorganization or liquidation.
- The approval of the plan: Once the court has determined that the reorganization plan is fair, equitable, and feasible, the plan, along with a summary, is given to the firm’s creditors and shareholders for their acceptance. For the plan to be approved, written acceptances from creditors holding two-thirds of the amount of the claims filed are necessary. When the firm is insolvent, written acceptances form the majority of both the preferred and the common stockholders are required. The plan, once approved, is put into effect as soon as possible.
- The payment of expenses: After the reorganization plan has been approved or disapproved; the trustee and all parties to the proceedings whose services were beneficial or contributed to the approval or disapproval of the plan file a statement of expenses. If the court finds these claims acceptable, the debtor must pay these expenses within a reasonable period.
The trustee’s responsibilities
Since reorganization activities are placed largely in the hands of the court-appointed trustee, it is useful to understand the trustee’s responsibilities. His three key responsibilities are the valuation and recapitalization of the firm and the exchange of outstanding obligations for new securities.
Discussion and analysis
Reorganization involves valuation of the firm and the most difficulty of all is recasting of the company’s capital structure to reduce the amount of fixed charges. In formulating a reorganization plan, there are three steps. First, the total valuation of the reorganized company must be determined. This step, perhaps, is the most difficult and the most important. The technique favored by trustees is a capitulation of prospective earnings. Various models are used to predict bankruptcy.
In order to determine this, the trustee must estimate both the liquidation value of the enterprise and its value as a going concern. If the trustee finds that its value as a going concern is less than its liquidation value, he will recommend liquidation; if he finds the opposite to be true, he will recommend reorganization. The procedure used to determine the liquidation value of the firm is similar to that described in the discussion of valuation. Estimating the value of the reorganized firm as a going concern involves forecasting its sales and the earnings from those sales. By applying an appropriate capitalization rate, the present value of forecast earnings can be transformed into the value of the firm as a going concern (White, Sondhi, and Fried 1999).
Some of the models that are used to predict bankruptcy include multivariate models and univariate models. One of the models compares a theoretical model of bankruptcy with the variables used in Altman et al.’s ZETATM predication model. In Scott’s model, debt (interest) payments (R) can be made from current earnings before interest and taxes (EBIT) or from the firm’s equity. This equity is defined as the present value of the firm’s future dividends and is symbolized by S. Thus bankruptcy occurs when R > EBIT + S. Alternatively, bankruptcy is defined as EBIT R – S.
If we let, uEBIT represent the expected (average) EBIT and SEBIT the standard deviation of EBIT, the equation can be standardized.
Dividing the numerator and denominator of the right-hand side of this equation by total assets (TA) and rearranging terms yield
Scott points out that although the functional form differs, all the ratios in the right-hand side are represented (exactly or in surrogate form) in ZETATM.
The valuation figure is subject to considerable variation, owing to the difficulty of estimating prospective earnings and determining an appropriate capitalization rate. Thus, the valuation figure represents nothing more than a best estimate of potential value. Although the capitalization of prospective earnings is the generally accepted approach of valuing a company in reorganization, the valuation may be adjusted upward if the assets have substantial liquidating value.
Once a valuation figure has been determined, the next step is to formulate a new capital structure for the company, to reduce fixed charges so that there will be an adequate coverage margin. To reduce these charges, the total debt of the firm is scaled down by being partly shifted to income bonds, preferred stock, and common stock. In addition to being scaled down, the terms of the debt may be changed.
The maturity of the debt can be extended to reduce the amount of annual sinking-fund obligation. If it appears that the reorganized company will need new financing in the future, the trustee may feel that a more conservative ratio of debt to equity is needed to provide for future financial flexibility. There is conservative use of debt when the liquidated value of assets is less than the economic value of assets. When the current value placed on a company is importantly based on future cash flows, known as a futures option, as opposed to being based on hard asset values.
Once a new capital structure is established, the last step involves the valuation of the old securities and their exchange for new securities. In general, all senior claims on assets must be settled in full before a junior claim can be settled. In the exchange process, bondholders must receive the par value of their bonds in another security before there can be any distribution to preferred stockholders.
In most cases, the debtor has the sole right to draw up a reorganization plan and to file it within a reasonable time. If a plan is not proposed by the company, the trustee, the debtor, the creditors’ committee, or individual creditors, or than one plan can be filed. All reorganization plans must be submitted to creditors and stockholders for approval. The role of the court is to review the information in the plan, to make sure disclosure if full.
Characteristics reorganization
- Poor liquidity: In order for a company to apply for reorganization under chapter 11, they should be having financial problems. When a company fails to meet creditors’ obligation it is said it is under financial distress and they cannot meet all obligations due to liquidity problem. Reorganization becomes an escape from bankruptcy. When a company is in trouble of meeting obligations creditors fear of losing their money. Therefore, they may apply for bankruptcy in the process of trying to recover their money.
- Poor financial performance: When a company is performing poorly for a long period it accumulates losses and borrows heavily to finance its operations. It may reach a point that the roles become greater than financing aspect of the business. In such a situation, the company may be forced to apply for voluntary bankruptcy, which may end up, be reorganization if there is an agreement with creditors.
- High degree of advantage: When a company has high debts they will reorganize their operations as well as their capital structure in order for them to remain in business.
Reorganizations at General Motors
General Motors has been experiencing financial distress, and in the year 2010, they reorganized their operations and capital structure after President Obama intervened. The company by 2010 and the total equity of 23,015,000,000 out of this only 5,000,000 was common stock. The company was heavily indebted but most of figure in the equity was good will, which could not be sold, meaning that the company had a negative equity. This meant that the recorded good will was greater than the assets of the company thus; reorganization became the only option out. The company began the process of reorganization under chapter 11something that improved their balance sheet possession in the year 2010 (Wall street Journal, 2010).
Table 1: Balance Sheet.
The company had accumulated billions of dollars in debt, which led the company to downsize its employees, close various branches and reduce production in total. The company had accumulated a debt of about 70 billion U.S dollars however, after filing for reorganization it has 17 billion in debt (General Motors, 2010).
Looking at balance sheet of the company before and after reorganization, you will realize that the company financial position and fortune changed. From the July 10th, the company improved its operation even the financial result improved drastically.
Table 2: General Motors Company and Subsidiaries, condensed consolidated statements of cash flows (in millions).
The debtor in Possession (DIP) and Automatic Stay
When a company is facing a financial problem, chapter 11 provides debtors to keep possession of those assets, which were given as a guarantee for the loans. However, they are not required to sell this asset and they require using this as a financing option for the company. In this case, the company remains in business holding the properties, which are meant for creditors. General Motors is the best example of the debtor in possession they continued to possess properties, which were guaranteed to creditors, and they emerged. Automatic stay ensures the company continues with business without being sued by creditors. The automatic stay arises when a debtor in possession cannot be sued because of some credit.
Valuation of reorganized company
After this cash was forecasted it was used to value the company using weighted average cost of capital. The weighted average cost of capital was estimated using the following formula,
Table 3: Weighted Average Cost of Capital.
Cost of equity
Rs = Rf + Bs (Rm – Rf)
Where:
- Rs – cost of equity capital
- Rf– the return that can be earned on a risk – free investment (e.g. US Treasury bill)
- Rm – the average return on all securities (e.g., S & P 500 stock index)
- Bs – the securities beta (systematic) risk.
- Rs = 3.65 + 1 (10 – 3.65)
It is easy to see that the required return for a given security increases with increases in its beta. In this case, we used the cost of debt as the weighted cost of capital because the company has a negative equity. The cash flows generated for the next four years were:
(all figures in millions)
The free cash flow to equity model computes equity value at time t by replacing expected dividends with expected free cash flows to equity.
Vt = free cash flow
WACC
Free cash flow to equity are defined as cash flows from operations less capital expenditures and adjustments for changes in debt. They are cash flows that are free to be paid to equity investors and, therefore, are an appropriate measure of equity investors’ payoffs.
Free cash flows also can be defined for the entire firm. Specifically, free cash flows to the firm equal operating cash flows less investments in operating assets. Then, the value of the entire firm equals the discounted expected futures free ash flows using the weighted average cost of capital.
The value of the business was found to be 283,466,830/0.11725 = 2,417,627,548
The value of the business that the company should be willing to pay is 2,417,627,548 payable to debtors who are currently the supplier of capital as holders of equity have a negative figure.
Bankruptcy
If the parties fail, a crucial assumption in the market models is that the cost of insolvency or bankruptcy is zero. If a firm fails, assets presumably can be sold for their economic value. No legal or selling costs are incurred. After creditors have been paid, the residual proceeds are distributed to stockholders. As long as assets can be sold at their economic value in a frictionless world, investors can effectively diversify their risk. Under teal-world conditions, however, assets often have to be sold in bankruptcy at distress prices. Moreover, there are selling costs, legal fees, and other out-of –pocket costs.
Finally, and probably most important, there are a number of delays and inefficiencies involved in the process of going through a bankruptcy. Impending bankruptcy repels suppliers, who fear that the company may not be able to pay them. Employees leave in anticipation of doom. Sales drop off as customers worry about the reliability of the product and service. These developments make operations inefficient, to say the least (Brealey, Myers, and Marcus, 2007).
A legal process delays creditor takeover, during which asset values deteriorate. All of this becomes a “drain on the system” to suppliers of capital, and it works either directly or indirectly to the detriment of stockholders, the residual owners of the firm. The idea is that there are a number of stakeholders in the company – debt holders and common stockholders to be sure, but also customers, employees, governments, and people in communities where facilities are located.
When total risk increases, the cost of doing business rises. In turn, this weakens the company’s chances for survival. If there were no costs to bankruptcy and the firm could go through a costless reorganization or liquidation, stockholders might not care as long as the firms were committed to doing those things that it did best. However, with significant bankruptcy costs, stockholders will be affected and may view diversification of assets in a different light (Bake, 2009).
The probability of a firm’s becoming insolvent depends on its total risk, not just on its systematic risk; therefore, a case can be made for choosing projects in light of their effect on both the systematic and the total risk of the firm. However, another way, when insolvency or bankruptcy costs are significant, investors may well be served by the firm is paying attention to the total risk of the firm, not just to its systematic risk. Risky capital budgeting proposals can alter the total risk of the firm apart from their effect on its systematic risk. To the extent that unsystematic risk is a factor of at least some importance, total risk should be evaluated (Brealey, Myers, and Marcus, 2007)
Conclusions, implications, and limitations
When a capital structure is established for the reorganization company the company is reorganized and each claim is settled in full before a junior claim is settled. Debt instruments may be exchanged entirely for common stock in the reorganized company, and the old common stock may be eliminated. Only the straight and subordinated debenture holders would receive a settlement in this case. The preferred and the common stockholders of the old company would receive nothing.
Reference List
Bake, Harold Kent. 2009. Dividends and Dividend Policy. New Jersey: John Wiley & sons.
Brealey, Richard, Myers, Stewart & Marcus, Alan. 2007. Fundamentals of corporate finance. Boston: McGraw-Hill Irwin.
General Motors. 2010. General Motors Announces the New Company’s 30 Preliminary Managerial Results. Web.
Harold, Bierman. 2001. Increasing Shareholder Value: Distribution Policy, A Corporate Finance Challenge. Massachusetts: Kluwer Academic Publishers.
Harold, Bierman. 1999. Corporate financial strategy and decision making to increase shareholder value. Pennsylvania: Frank J. Fabozi Associates.
Wall street Journal. 2010. GM Picture Brightens as Sales Rise. Web.
White, Gerald, Sondhi, Ashwinpaul & Fried, Dov. 1999. The Analysis and Use of Financial Statements. New York: John Wiley & Sons.