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Session 3: Corporate Restructuring in Financial Distress

NES MIF, 2012 Sergey Sanzhar Citi

Outline

What is Financial Distress Framework of Analysis Capital Infusion Out-of-court Restructuring Out- ofFormal Bankruptcy Valuation in Financial Distress

1. What Is Financial Distress?

Its All About Liquidity!


Cash and other liquid assets are insufficient to meet current debt obligations. Violation of covenants can trigger distress: Covenant violations are meant to provide early signs of distress. Note: A firm in financial distress may or may not be insolvent, i.e., have liabilities with face value exceeding the assets value. assets

Why Are We in Distress?


A firm is underperforming and has high Leverage. Why? Bad strategy / Bad luck / Bad execution. Is it financial or economic distress?
Is the current underperformance caused by too much leverage? Or was underperformance in the first place the cause of financial distress? In other words, would the firm be healthy if it were not for its high leverage?

2. A Framework of Analysis

XYZs Balance Sheet


Assets:
If good state next year: $100m. If medium state next year: $30m. If bad state next year: $5m.

Liabilities: Face value $35m due next year. Discount rate: 10% throughout.

Status Quo Values


Valuation (@10%):
Equity: Debt: ( 1/3 x 65 + 1/3 x 0 + 1/3 x 0 ) / 1.10 = $19.7m. 1.10 $19.7m. ( 1/3 x 35 + 1/3 x 30 + 1/3 x 5 ) / 1.10 = $21.2m. 30 1.10 $21.2m.

State Good Medium Bad Value

Proba. 1/3 1/3 1/3

Assets 100 30 5

Creditors 35 30 5 21.2

Shareholders 65 0 0 19.7

Investment Opportunity
XYZ has an investment project:
Today: Investment outlay $15m. 15m. Next year: Safe return $22m. 22m.

XYZ should invest: invest: NPV = -15 + 22/1.10 = $5m. 22/1.10 However, no internal funds are available. Will XYZs shareholders inject new capital? XYZ

Will Shareholders Inject New Funds?


State Good Medium Bad Proba. 1/3 1/3 1/3 Assets 122 52 27 Creditors 35 35 27 29.4 21.2 Shareholders 87 17 0 16.5 19.7

Value (net of 15m) Value under status quo

XYZs equity is worth: XYZ ( 1/3 x 87 + 1/3 x 17 + 1/3 x 0 ) / 1.10 = $31.5m. 1.10 XYZs shareholders will not inject funds: XYZ funds:
They invest $15m. Equity value increases only by $31.5m $19.7m = $11.8m. They lose the difference: $3.2m.

Whats Happening? Debt Overhang


Shareholders would:
Incur the full investment cost ($15m). ($ Get only part of the return (full $22m only in the good state).

Existing creditors would:


Incur none of the investment cost. Still receive part of the return.

Existing risky debt acts as a tax on investment. investment Near financial distress, shareholders are reluctant to fund good projects because much of the gains go to creditors.

Debt Overhang: Its Worse in Bad Times


What if the probability of the bad state is 1/2 instead of 1/3? The creditors grab part of the return even more often. creditors Therefore:
The tax on investment is increased. tax The shareholders are even less inclined to invest.

As financial distress becomes more likely, companies find it increasingly difficult to invest.

What Can Be Done About It?


Infusions of new capital:
New equity injection? injection? New debt financing? financing? Merger?

Restructure the firms liabilities: firm


Private workout, i.e., out-of-court restructuring. out- ofFormal bankruptcy procedure. procedure.

What Happens in Financial Distress


No financial restructuring
49%

Financial Distressworst 5% 3-yr return


47% 51%

Private workout

Financial restructuring
83% 53%

Reorganize and emerge

Legal bankruptcy Chapter 11

7%

Merge with another firm

10%
Source: Karen H. Wruck, Financial Distress: Reorganization and Organizational Efficiency, Journal of Financial Economics 27 (1990), Figure 2.

Liquidation

3. Capital Infusion

New Equity Injection


Near financial distress, firms may be unable to raise equity because most of the benefits would go to existing creditors.

New Debt Financing


Issuing new debt junior to the existing debt will not work: The tax on investment is unchanged. work: tax Issuing debt with same seniority as the existing debt will reduce but generally not solve the problem: A (smaller) tax remains. Debt that is senior to existing debt avoids the tax on investment because gets a large part of the return: return:
either actual seniority, seniority, or shorter maturity (because it is de facto senior). (because senior).

But this may be prohibited by existing covenants.

New Debt Financing (cont.)


For new financing:
Debt is easier than equity. Senior debt is easier than junior debt. Short-term debt is easier than Long-term debt. ShortLong-

Conversely, new financing is more difficult when existing debt is:


Short term debt. Protected by covenants against new (senior) debt issues. Warning: Many firms in distress increase ST debt, delay actual distress but eventually hit the wall with very high leverage.

Merger
Merging with another company can help but only if the acquirer brings a better capitalization and more liquidity. However, unless the acquirer is planning some changes in operations, this is like an equity injection. Indeed, the acquirer must assume the companys company liabilities. If equity injection failed, why would merger succeed? Need to combine this with other moves.

4. Out-of-Court Restructurings

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Financial Restructuring
In principle, restructuring could avoid the inefficiency:
Debt-for-equity exchange. Debt- forexchange. Debt forgiveness or rescheduling. rescheduling.

Suppose a negotiator proposes the following deal:


The firm issues new equity to fund the project. Creditors write down $7m in face value to $28m, i.e., face value reduced by 7/35=20%.

Will shareholders agree? agree? Will creditors agree?

Financial Restructuring (cont.)


State Good Medium Bad Proba. 1/3 1/3 1/3 Assets 122 52 27 Creditors 28 28 27 Shareholders 94 24 0

Shareholders will agree:


Total equity value: (1/3x94 + 1/3x24 +1/3x0) / 1.10 = 1/3x24 1.10 $35.8m New equity must be worth: $15m Old equity is worth: $35.8 - $15 = $20.8m This exceeds the status quo value: $19.7m. $19.7m.

Creditors will agree:


Debt value: (1/3x28 + 1/3x28 +1/3x27) / 1.10 = $25.2m 1/3x28 1.10 This exceeds the status quo: $21.2m

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Using this Sensibly


When evaluating costs of financial distress, account for the possibility of (mutually beneficial) financial restructuring. In practice, perfect restructuring is not always possible. But you should ask: What are limits to restructuring?
Banks and private debt vs. bonds. bonds. Few vs. many banks. banks. Bank relationship vs. arms length finance. arm finance. Simple vs. complex debt structure (e.g., number of classes with different seniority, maturity, security, .). .).

Using this Sensibly (cont.)


Somehow, (some of) the existing creditors need to share in the investment cost. This can be achieved through:
Issuing new senior (and/or short-term) debt (see Appendix D). shortNegotiating with existing creditors so that they accept to:
reduce their debt, extend its maturity, and/or exchange (some of) it against equity.

This causes particular problems when dealing with public debt.

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Public Debt Restructuring


Problem: In the US, changing the principal, interest or maturity of a public debt issue requires the approval of all bondholders (Trust Indenture Act of 1939). In the UK, 75 percent is enough. Response: Exchange offers.
Exchange debt against new debt, equity and/or cash. Non-tendering bondholders maintain their claims. NonThe Act is not violated.

Issue:
In principle, an appropriate offer could avoid distress costs. But dealing with dispersed bondholders is not frictionless frictionless

Public Debt Restructuring


See Appendix F

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5. Formal Bankruptcy

Bankruptcy
An orderly, non-violent and somewhat predictable way nonof dealing with failure to pay debts. Initiation of bankruptcy procedure:
By a creditor, who petitions a court to declare a bankruptcy on creditor, petitions the basis of evidence of an act of bankruptcy (when creditor is bankruptcy not paid due amount). By the debtor. debtor.

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Bankruptcy in the US
In-Court: InLiquidation (Chapter 7 in US). Restructuring (Chapter 11 in US).

Pre-packaged Bankruptcy PreCombines workout and Chapter 11.

Auction Bankruptcy Law (e.g., Chapter 7)


The court appoints a trustee to do the following. Shut down the firm. Sell the assets for cash, piecemeal or as a going concern.
Sale in auction, private sale, etc. Possibly sold to the previous owners.

Distribute the proceeds to the firms claimholders firm according to Absolute Priority Rule (APR).

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Priority List
Secured claims, including debt incurred while in claims, bankruptcy. Administrative claims (i.e., lawyers fees): lawyers Employee compensations claims up to some cap. Employee benefit plan claims up to some cap. Customer claims up to some cap. US Tax and Social Security claims. claims. General unsecured claims and some foreign tax claims. Preferred stock. Common stock.

Problems/Concerns
Shutting down the firm can destroy value. Fire sale prices:
Must sell now! Weak position. Natural buyers (usually trade buyers) may not be able to buy the assets or at least not pay much for them due to:
Antitrust. Whole industry may be in distress.

Excessive piecemeal liquidations, i.e., the firm may be worth more as a going concern.

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Structured Bargaining Bankruptcy Law


US Chapter 11: Creditors have to lay off while the debtor puts together a reorganization plan. plan. Aim: Avoiding some costs of unstructured bargaining and straight liquidation by:
Buying time and preventing a creditors race. creditors Organizing bargaining, i.e., who can do what when, etc. Reducing some information asymmetries.

Note: No real equivalent to this in many other countries, countries, though superficially similar laws often exist. Moving towards this.

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Chapter 11
Main features:
Automatic Stay. DIP financing. Voting procedure.

Key facts:
Routine deviations from APR. Administrative fees about 2%-5% of assets. 2%Average time in bankruptcy: about 20 months.

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Automatic Stay
Main features:
Stop payments to unsecured creditors.
This includes tax collection.

Secured creditors cannot seize collateral but interest continues to accrue.

Effect 1: Avoids a creditors race to grab the assets in a creditors disorganized and value-destroying way. valueEffect 2: Extends de facto the maturity of the existing debt Reduces the debt overhang problem.

Debtor-in-Possession (DIP) Financing


Subject to court approval, the following can happen. DIP financing:
New senior debt can be issued, even against existing covenants. New debt can even be senior to other administrative costs.

Cash collateral agreements: Operations can be financed using liquid assets already pledged as collateral. Effect: Reduces the debt overhang problem.

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Reorganization Procedure: Exclusivity Period


Current management and BOD retain control. Exclusivity period:
For 120 days, only they can file a reorganization plan. Another 180 days to get approval. Judge can extend/reduce deadlines (frequent extensions). After that, other parties propose alternative plans.

Committees and trustees for the different claimholder classes negotiate the reorganization plan:
Size of the pie: What to do with the assets? Sharing the pie: Who gets what?

Delta Airlines
WSJ, March 6, 2007:
Delta Air Lines Inc., which is operating under bankruptcy-court bankruptcyprotection, asked for court permission to delay the deadline for exclusively filing its reorganization plan and soliciting acceptance acceptance of that plan The carrier wants to prevent other plans from plan being filed with the U.S. Bankruptcy Court in Manhattan until after it can finish soliciting votes on its plan, which calls for the for airline to emerge as a stand-alone carrier. stand-

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Reorganization Procedure: Voting Mechanism


Majority Voting Mechanism:
Classes: regroup creditors with similar claims. 2/3 in face value and bondholders in each class. For stockholders: 2/3 majority to approve

Only a group whose claim is impaired (receives something, but not impaired its full claim), can vote for or against the reorganization plan. plan. Since the decision as to which groups will receive value is based value on the valuation of the company, the valuation is often contentious. contentious.
Senior claimants want under-valuation under- valuation Junior claimants want over-valuation over- valuation

Voting Mechanism
Normally, a reorganization plan is confirmed if all classes of creditors who have the right to vote accept the plan.
Dissenting members in a class have some rights. They must receive, at a minimum, the value they would receive in a Chapter 7 liquidation.

Cramdown procedure: The court can impose a plan vetoed by some classes of claimants.
The judge need only ensure that the plan is fair and equitable equitable and does not discriminate unfairly against any class. unfairly Also, the judge needs to ensure that the dissenting class has received its allowable claim before a junior class claim gets any value. In general, it is unsecured creditors who are crammed down.

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Voting Mechanism
Note:
Unlike in exchange offers, bondholders are not treated differently depending on their decision. Procedure reduces the debt overhang problem. Trust Indenture Act Firms cannot mimic Chapter 11. cannot mimic In principle, a judge can effect a cramdown as long as at least one class votes for the plan.

Maintenance of Equity Value


Typically, shareholders receive a stake in the reorganized firm even if creditors are not paid in full (i.e., deviation from APR). The plans sponsor can threaten to push for a plan cramdown. cramdown. Maybe a bribe to avoid that shareholders/mgt bribe follow value-destroying tactics prior to or during the valuebankruptcy procedure.

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5.2 Some Issues

Some Problems and Concerns


The procedure is costly:
Legal and administrative costs: Average 3% of assets. costs: Long: 2/3 of cases take 2 to 3 years.

A lot depends on the courts (rather than markets) court market valuation:
Liquidation vs. going concern. Financial restructuring. DIP financing authorization: Can lead to abuses because existing creditors bear the cost while shareholders propose.

What is the courts objective? court

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Some Problems and Concerns (cont.)


Existing management remains in control.
Didnt they get the firm in trouble in the first place? Didn Exclusivity period is routinely extended. Much influence over the procedure.

Unfair to the companys competitors? company

Private Restructuring vs. Bankruptcy


Less costly than Chapter 11: lower costs and much quicker. No court intervention. Shareholders and creditors do better. (But endogeneity?) Firms restructure out-of-court when: out- ofMore assets are intangible, i.e., less secured debt. Simpler liability structure: Fewer classes of debt, simpler public public debt structure, more bank debt than public debt, etc.

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Why Not Always Workout?


Recall the advantages of Chapter 11: 11:
DIP financing. Automatic stay. Easier to get plan through.

Also, favourable tax treatment of TLCF.


Net Operating Losses (NOL). Debt forgiveness non taxable.

Tax Advantage of Bankruptcy


Example 1: Creditors agree to exchange some debt against equity. Now own over 50% of the equity. In private workout, the company could lose its NOLs. NOLs. In Chapter 11, they are maintained. Example 2: Creditors agree to cancel a fraction of debt. In private workout, this amount treated as taxable income. In Chapter 11, it is not.

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Pre-Packaged Bankruptcies
A reorganization plan is filed together with the bankruptcy petition (pre-voted or post-voted plans). (prepostTax and voting rule benefits (e.g. cramdown). cramdown). Less costly than traditional Chapter 11 proceedings:
Lower administrative costs. Much quicker: ~ 2 months.

6. Valuing Financially Distressed Companies


APV and CCF Valuation

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DCF Valuation of Distressed Companies


Companies in financial distress have:
High and changing leverage: WACC is difficult. Lots of valuable tax shields (debt tax shields and net operating losses).

As a general rule:
1. 2.

Model explicitly the future debt structure and tax liability. Use APV.

This notes:
Shows how to use APV to value a company in financial distress.

APV Method
Total Cash Flows allocated to 3 buckets
CF generated by the business
Defined as EBIT*(1-t) + Adjustments (Depr, Capex, NWC, A sales) EBIT*(1(Depr, Discounted at Ra.

CF generated from Interest Tax Shields


Defined as I*t Discounted at Rd or Ra.

CF generated by NOL Carry Forwards


Defined as N*t Discounted at Rd or Ra.

Enterprise Value = sum of above 3 discounted cash flows.


CCF is the same as APV method when the three cash flows are discounted at the same rate, Ra.

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APV Method (cont.)


APV uses hypothetical taxes ((R-C-D)*t) and computes ((Rthe PV of the NOLs and Interest Tax Shield separately. Why? These are the taxes of a hypothetical company with no debt and no NOLs. NOLs. Actual Taxes Payable = (R-C-D-I-N)*t (RInterest Tax Shield = I*t See Appendix E for examples.

Appendix A: More Details on Chapter 11

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Voting Procedure
Within each group that gets to vote, two thirds of the dollar value of all claims in that groups and a simple majority of that group must vote for the plan. For stockholders, a two-third majority of shares is tworequired to vote for the plan. The above calculations are done with respect to class members who actually vote and not the total potential members of that class.

Cramdown
Secured creditors can be crammed down only if the creditors continue to maintain their liens and receive future claims whose value is the past-due amount plus value pastinterest. Unsecured creditors can be crammed down only if they receive at least their value in a liquidation, and no equityholders receive anything unless the value they value obtain under the plan is equal to the amount owed to them.
In general, it is unsecured creditors who are crammed down.

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Appendix B: Some Bankruptcy Statistics

Creditor Rights Around the World


Does system have a creditor-friendly characteristic. creditorYes 1. Yes No 0. No Crude comparison but: UK is more creditor-friendly than creditorFrance.
No Automa tic Sta y Cana da Fra nce Germa ny Italy Japan UK US 0 0 1 0 0 1 0 Secured Creditors Paid First 1 0 1 1 1 1 1 Restrictions for Going into Reoganiza tion 0 0 1 1 0 1 0 Mgt Exits in Reorganization 0 0 0 0 1 1 0 "Total" Creditor Rights 1 0 3 2 2 4 1

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Appendix C: UK vs. US

Bankruptcy in the UK
Out-of-Court: Out- ofLiquidation. Receivership.

Administration. Company Voluntary Arrangement (Not successful).

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UK Liquidation
Basically a burial. Liquidator is appointed to:
Sells the assets. Distribute the proceeds to claimholders along APR.

UK Receivership
Floating Charge: Secured creditors with a general claim on the company assets. Receiver appointed by and administers the firm on behalf of the Floating Charge. Does not have to care about other creditors. Receiver has considerable power and can raise new funds, but new funds are junior (i.e., no DIP financing). No automatic stay: Creditors with fixed charge can charge repossess their assets if they want.

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UK Administration
Administrator appointed by the Court. Has three months to propose a reorganization plan. The plan is voted by all creditors (majority vote by value). Old management play no role (i.e., no exclusivity period). Automatic stay. Floating Charge can veto administration and appoint a receiver.

Main Differences with U.S.


More emphasis on:
Protecting creditors. Punishing management: They lose control. Punishing

Less emphasis on rescuing a troubled company.

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Appendix D: Practice Problems


Under-investment and over-investment Underoverunder different bankruptcy codes: US vs. UK

XYZs Balance Sheet


Assets:
If medium state next year: $30m. If bad state next year: $5m.

Liabilities: Face value $35m due next year.


Senior debt: $20m. Junior debt: $15m.

Discount rate: 10% throughout.

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Liquidation Values
Valuation (@10%):
Senior Debt: ( 1/2 x 20 + 1/2 x 5 ) / 1.10 = $11.4m. 20 1.10 $11.4m. Junior Debt: ( 1/2 x 10 + 1/2 x 0 ) / 1.10 = $4.5m. 10 1.10 $4.5m. Equity: ( 1/2 x 0 + 1/2 x 0 ) / 1.10 = $0. 1.10 $0.

State Medium Bad Value

Proba. 1/2 1/2

Assets 30 5

Senior Creditors 20 5 11.4

Junior Creditors 10 0 4.5

Shareholders 0 0 0.0

Scenario 1: Good Investment Opportunity


XYZ has an investment project:
Today: Investment outlay $15m. 15m. Next year: Safe return $22m. 22m.

XYZ should invest: invest: NPV = -15 + 22/1.10 = $5m. 22/1.10 However, no internal funds are available. Recall (the lecture): Shareholders will not inject new capital.

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In US Chapter 11
DIP financing:
New investors lend $15m. Debt is senior to all existing debt. Here DIP happens to be risk-free. Interest rate 10%. riskRepayment next year: (1+10%) x 15 = $16.5m.
Senior Creditors 20 10.5 13.9 11.4 Junior Creditors 15 0 6.8 4.5

State Medium Bad Value Status Quo

Proba. 1/2 1/2

Assets 52 27

DIP 16.5 16.5 15.0

Shareholders 0.5 0 0.2 0

Whats Happening?
XYZ can raise capital and invest. Everybody is better off:
Senior creditors improve from $11.4m to $13.9m. Junior creditors improve from $4.5m to $6.8m. Shareholders improve from $0 to $200k.

Total improvement $5m. improvement

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In UK Receivership
Receiver appointed by senior creditors (floating charge).
Decides whether to invest. The receiver can approach existing or new creditors. New debt is junior to existing debt.

State Medium Bad Value

Proba. 1/2 1/2

Assets 52 27

Senior Creditors 20 20 18.2

Junior Creditors 15 7 10.0

Leftover for New Debt 17 0 7.7

Shareholders 0 0 0.0

Whats Happening?
Can raise at most $7.7m. Cannot invest.

Issuing most junior debt cannot solve debt overhang. This is because senior (and existing junior debt) do not participate in the investment cost. Chapter 11 is better!

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Scenario 2: Bad Investment Opportunity


XYZ has an investment project:
Today: Investment outlay $15m. $15m Return next year:
Medium state: If lucky (probability 2/3): $44m. Medium state: If unlucky (probability 1/3): $0. Bad state: $0.

XYZ should not invest: invest: NPV = -15 + 1/2 x 2/3 x 40/1.10 = -$2.9m. 40/1.10 $2.9m.

Chapter 11
Management is in charge. May be able to convince the court to allow $15m DIP financing (e.g., by exaggerating revenues).
Here DIP is risky. Expected return 10%. Promised repayment: $28m.
Senior Creditors 20 2 0 6.4 11.4 Junior Creditors 15 0 0 4.5 4.5

State Proba. Medium (lucky) 1/3 Medium (unlucky) 1/6 Bad 1/2 Value Status Quo

Assets 70 30 5

DIP 28 28 5 15

Shareholders 7 0 0 2.1 0

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Whats Happening?
XYZ can raise capital and invest.
Senior creditors are worse off (lose $5m). Junior creditors are indifferent. Shareholders are better off (gain $2.1m).

Junior creditors would be:


Worse off if Proba(Lucky)<2/3. Proba(Lucky)<2/3. Better off if Proba(Lucky)>2/3. Proba(Lucky)>2/3.

Intuition: They are between senior debt and equity. Might gang up with shareholders against senior creditors.

UK Receivership
Can raise at most $7.7m. Receivership is better! Cannot invest.

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Appendix E: Capital Cash Flows Method of Valuation

Definitions
NOL = Net Operating Losses NWC= Net Working Capital R = Revenues C = Cost of Sales + Selling, General & Admin Expenses D = Depreciation I = Interest Expense N = Taxable Income net of NOL carry forwards t = Marginal Tax Rate CFA (Cash Flow Adjustments) = Depreciation - Capex - Increase in NWC + Excess Cash + Proceeds from Asset Sales

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Definitions (cont.)
EBITDA = (R-C) (REBIT (Earnings Before Interest & Tax) = (R-C-D) (RTaxable Income = (R-C-D-I-N) (REBIAT (Earnings Before Interest After Tax) = (R-C-D)*(1-t) (R- D)*(1NI (Net Income) = (R-C-D-I)*(1-t) + N*t (RI)*(1Taxes Payable = (R-C-D-I-N)*t (RInterest Tax Shield = I*t NOL Tax Shield = N*t Ra = Cost of Assets Rd = Cost of Debt Re = Cost of Equity Rf = Risk-free rate RiskRm = Expected Market Return Rm-Rf = Market Risk Premium RmB = Levered Equity Beta Ba = Unlevered Beta or Asset Beta.

CCF Method
Estimate Total Cash Flows
CF generated by the business
Defined as NI + CFA + I (Net Income version) Or as, EBIT Taxes Payable + CFA (EBIT version) Or as, EBITDA Taxes Payable + CFA D (EBITDA version) (See earlier definitions slides for above definitions).

CF generated from Interest Tax Shields


Defined as I*t.

CF generated by NOL Carry Forwards


Defined as N*t.

Discount Total Cash Flows at Ra.

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CCF Method (cont.)


Same as APV method when the three cash flows are discounted at the same rate, Ra. For this reason, CCF Method is sometimes called compressed APV. APV

Example
Note: Assume that the firm uses all available net cash flows (= free cash flows - after tax interest expense) to pay down debt each year through year 5, then maintains debt at a constant level thereafter Inputs Initial Debt Initial net operating loss carry forwards (NOLs) Expected rate of return on debt (Rd) Expected rate of return on equity (Re), initial value Asset beta (Ba) Long term US govt bond rate (Rf) Market risk premium (Rm-Rf) Expected rate of return on assets (Ra), where Ra = Rf + Ba(Rm-Rf) Long term annual growth rate (g) Marginal corporate tax rate (t) 300 140 8.0% 14.8% 0.8 6.0% 7.5% 12.0% 3.0% 34.0%

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APV
Panel A: Proforma debt projection Line # 1 2 3 4 5 6 7 8 9 10 11 EBIT Interest expense Profit before tax Taxes (@ 34%) (after NOL utilization) Net income + Depreciation - Capex - Investment in net working capital + Excess cash + Proceeds from asset sales Net cash flow 1 32.0 (24.1) 7.9 0.0 7.9 90.0 (95.0) (16.0) 8.0 3.0 (2.1) 300.0 302.1 2 34.4 (24.5) 9.9 0.0 9.9 93.0 (96.0) (17.2) 0.0 1.0 (9.3) 302.1 311.4 Year 3 87.8 (23.4) 64.4 0.0 64.4 98.0 (105.0) (18.5) 0.0 0.0 38.9 311.4 272.5 4 90.2 (20.3) 69.9 (4.1) 65.8 105.0 (115.0) (19.0) 0.0 0.0 36.8 272.5 235.7 5 163.2 (16.1) 147.1 (50.0) 97.1 112.0 (120.0) (20.4) 0.0 0.0 68.7 235.7 167.0

12 Beginning of year debt 13 End of year debt

APV (cont.)
Panel B: Cash flows from interest tax shields Line # 20 21 22 23 24 25 26 Average debt Interest expense (based on avg debt) Tax savings (@ 34% tax rate) Terminal value (CF5 / Rd) Present value of year 1-5 cash flows Present value of terminal value Total present value (discounted at Rd) 1 301.0 24.1 8.2 29.8 46.6 76.4 2 306.8 24.5 8.3 Year 3 292.0 23.4 7.9 4 254.1 20.3 6.9 5 201.4 16.1 5.5 68.5

Panel C: Cash flows from using net operating loss carry forwards (NOLs) Line # 27 28 29 30 31 Profit before tax NOLs used Cumulative NOLs used Reduction in taxes paid (line 28 * t) Total present value (discounted at Re) 1 7.9 7.9 7.9 2.7 30.7 2 9.9 9.9 17.8 3.4 Year 3 64.4 64.4 82.2 21.9 4 69.9 57.8 140.0 19.7 5 147.1 0.0 140.0 0.0

Panel D: Total enterprise value Sources of cash flow Cash flows from the business Cash flows from interest tax shields Cash flows from using NOL carryforwrds Total enterprise value Present value 615.2 76.4 30.7 722.4

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CCF (cont.)
Panel A: Net income version Line # 1 2 3 4 5 6 7 8 9 10 11 12 Net income (after NOL utilization) + Depreciation - Capex - Investment in net working capital + Excess cash + Proceeds from asset sales + Interest expense Capital cash flows Terminal value (CF5 * (1+g) / (Ra-g)) Present value of year 1-5 cash flows Present value of terminal value Total present value (discounted at Ra) 1 7.9 90.0 (95.0) (16.0) 8.0 3.0 24.1 22.0 160.5 550.6 711.1 2 9.9 93.0 (96.0) (17.2) 0.0 1.0 24.5 15.2 Year 3 64.4 98.0 (105.0) (18.5) 0.0 0.0 23.4 62.3 4 65.8 105.0 (115.0) (19.0) 0.0 0.0 20.3 57.1 5 97.1 112.0 (120.0) (20.4) 0.0 0.0 16.1 84.8 970.4

CCF (cont.)
Panel B: EBIT Version Line # 13 14 15 16 17 18 19 20 21 22 23 24 25 EBIT Taxes (@ 34%) (after NOL utilization) EBIAT + Depreciation - Capex - Investment in net working capital + Excess cash + Proceeds from asset sales Capital cash flows Terminal value (CF5 * (1+g) / (Ra-g)) Present value of year 1-5 cash flows Present value of terminal value Total present value (discounted at Ra) 1 32.0 0.0 32.0 90.0 (95.0) (16.0) 8.0 3.0 22.0 160.5 550.6 711.1 2 34.4 0.0 34.4 93.0 (96.0) (17.2) 0.0 1.0 15.2 Year 3 87.8 0.0 87.8 98.0 (105.0) (18.5) 0.0 0.0 62.3 4 90.2 (4.1) 86.1 105.0 (115.0) (19.0) 0.0 0.0 57.1 5 163.2 (50.0) 113.2 112.0 (120.0) (20.4) 0.0 0.0 84.8 970.4

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Appendix F: Public Debt Restructuring

Exchange for Same Priority Bonds


Suppose a negotiator proposes the same deal as before:
The firm issues new equity to fund the project. Bondholders write down 20% in face value.

Implementation:
Tender a bond with $100 face value. Receive same bond with $80 face value. Each bondholder decides whether to tender or not.

We know that everybody would be better off. But will this work?

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Exchange for Same Priority Bonds (cont.)


Suppose you hold 1% of bonds:
If you dont tender, keep 1% x 35 = $0.35m face value. don If you tender, get bond with 80% x 0.35 = $0.28m.

All other bondholders:


If none tenders, they retain 99% x 35 = $34.65m face value. If all tender, they get bonds with 80% x 34.65 = $27.72m.

Will you tender? Need to consider scenarios:


If enough other bondholders tender, deal goes through. Otherwise, the restructuring fails ( Say, liquidation). liquidation).

State Good Medium Bad Value

Proba. 1/3 1/3 1/3

IF ALL OTHER BONDHOLDERS TENDER If you don't tender If you tender Other Other Assets Bondholders You Bondholders You 122 27.72 0.35 27.72 0.28 52 27.72 0.35 27.72 0.28 27 26.66 0.34 26.73 0.27 24.88 0.31 24.90 0.25

State Good Medium Bad Value

Proba. 1/3 1/3 1/3

IF NO OTHER BONDHOLDER TENDERS If you don't tender If you tender Other Other Assets Bondholders You Bondholders You 100 34.65 0.35 34.65 0.28 30 29.7 0.3 29.76 0.24 5 4.95 0.05 4.96 0.04 21.00 0.21 21.02 0.17

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Exchange for Same Priority Bonds (cont.)


Other things equal, youre better-off with higher face you bettervalue. You dont tender. don All bondholders think alike. The exchange offer fails. Implications: Exchange offers for same priority debt is likely to fail. Even more so in exchange for equity or junior debt.

What Happened?
The offer fails even though this makes everybody worse-off. worse-

So why did it fail? What is the problem?


As a group, bondholders are better-off with the restructuring. betterBut each bondholder decides for himself ignoring the impact of his decision on the outcome of the restructuring attempt. Hold-out problem among bondholders. HoldFriction: Coordination failure due to dispersion of bonds.

Investors (e.g., Vulture Funds) can create value by buying blocks of bonds to improve coordination.

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Exchange for Senior Debt


Exit Consent:
An exchange for senior debt is achievable if a (qualified) majority of bondholders do tender. As before, non-tendering bondholders maintain their claims. non-

Consider the same deal as before but with senior debt:


The firm issues new equity to fund the project. Each bondholder decides between:
Keeping his $100 bonds. Exchanging them against senior $80 bonds.

Will this work?

State Good Medium Bad Value

Proba. 1/3 1/3 1/3

IF ALL OTHER BONDHOLDERS TENDER If you don't tender If you tender Other Other Assets Bondholders You Bondholders You 122 27.72 0.35 27.72 0.28 52 27.72 0.35 27.72 0.28 27 27.00 0.00 26.73 0.27 24.98 0.21 24.90 0.25

State Good Medium Bad Value

Proba. 1/3 1/3 1/3

IF NO OTHER BONDHOLDER TENDERS If you don't tender If you tender Other Other Assets Bondholders You Bondholders You 100 34.65 0.35 34.65 0.28 30 29.7 0.30 29.72 0.28 5 4.95 0.05 4.72 0.28 21.00 0.21 20.94 0.25

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Exchange for Senior Debt (cont.)


Other things equal, youre better-off with senior claim. you betterYou do tender. All bondholders think alike. The exchange offer succeeds. The initial plan has been implemented.
Implications: Exchange offers for senior debt are more likely to succeed. Same for exchange offers for STD or cash (think very shortshortterm very senior debt). Not really possible when existing debt is already very ST.

What Happened?
For each bondholder accepting the offer:
Cost: Lower face value Transfer to other bondholders + shareholders. shareholders. Benefit: Senior debt Transfer from other bondholders. bondholders.

Exchange offer designed so that for each bondholder, the gain exceeds the cost Tenders. Note:
The transfers among bondholders cancel out. In aggregate, transfer from bondholders to shareholders, which is what the restructuring is aiming to achieve.

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