Outline the ways firms can fix financial distress at its different stages and account for what each way implies and the difficulties it presents.
The idea
Remedies depend on how deep the distress is and whether the business is worth more alive than liquidated. Early on, firms use operational restructuring (cutting costs, closing plants, replacing management, selling non-core assets) and out-of-court financial restructuring (covenant waivers, maturity extensions, exchange offers, debt-for-equity swaps). Out-of-court deals are quick and cheap but suffer from holdouts. Each bondholder gains by refusing while others concede, and public bonds usually need near-unanimous consent to change payment terms. A debt-for-equity swap cuts debt but dilutes existing shareholders and shifts control to creditors. If a deal fails, the firm files for formal reorganization (Chapter 11, possibly prepackaged) or liquidation (Chapter 7). Reorganize when going-concern value exceeds liquidation value net of costs. Debt overhang also blocks fresh equity, because shareholders will not fund projects whose gains go to creditors.
Formulas
New shares issued in a debt-for-equity swap
New shares = N ÷ s − N
- N
- the shares outstanding before the swap
- s
- the share of post-swap equity kept by existing shareholders
Gross up by the share existing holders keep, not by the creditors' share. The swap cuts debt but dilutes existing holders and shifts control to creditors.
A practice question
Which of the following is a financial restructuring, as opposed to an operational restructuring, of a distressed firm?
- Closing unprofitable plants.Why not: Plant closures are operational restructuring, changing the business rather than the claims on it.
- Replacing the chief executive and senior management team.Why not: A management change is an operational/governance remedy, not a change to the capital structure.
- Exchanging a portion of its debt for newly issued equity. - correct
- Reducing headcount in administrative functions.Why not: Cost cutting is operational restructuring; the debt and equity claims are untouched.
Financial restructuring changes the claims on the firm: debt-for-equity swaps, maturity extensions, covenant resets, exchange offers. Operational restructuring changes how the business runs: costs, plants, management.
A harder one
A distressed firm has 100 million shares outstanding. Creditors agree to exchange debt for new shares so that they own 60% of the post-restructuring equity and existing shareholders retain 40%. How many new shares must be issued?
- 60 millionWhy not: Applies 60% directly to the existing 100 million shares instead of solving 100 / (100 + N) = 40%.
- 250 millionWhy not: Computes total post-swap shares (100 / 0.40) rather than the number of new shares.
- 66.7 millionWhy not: Inverts the ratio, using 100 x 0.40 / 0.60, which is the number of shares needed if existing holders held 60%.
- 150 million - correct
Existing shareholders keep 40%, so total shares = 100 / 0.40 = 250 million. New shares = 250 - 100 = 150 million. The swap cuts debt but heavily dilutes existing holders and hands control to creditors.
The hardest tier
A firm has senior debt of 700 and no other claims. Its going-concern value is 650 and its liquidation value is 400. A reorganization would cost 40 in fees and a liquidation 20. Closest to what is the difference in recovery rate (reorganization minus liquidation) for the debt holders?
- 32.9 percentage points - correct
- 35.7 percentage pointsWhy not: Ignores the costs of both processes, using 650/700 minus 400/700.
- 30.0 percentage pointsWhy not: Deducts reorganization costs but not liquidation costs: (610 - 400) / 700.
- 38.6 percentage pointsWhy not: Deducts liquidation costs but not reorganization costs: (650 - 380) / 700.
Reorganization net value = 650 - 40 = 610, recovery 610/700 = 87.1%. Liquidation net value = 400 - 20 = 380, recovery 380/700 = 54.3%. Difference = 32.9 points. Because reorganization yields more, creditors should favour it, but only after costs on both sides are netted.
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