Financial Distress and Restructuring Models

Author(s): Yehning Chen, J. Fred Weston and Edward I. Altman

Source: Financial Management, Vol. 24, No. 2, Silver Anniversary Commemoration (Summer,
1995), pp. 57-75
Published by: Wiley on behalf of the Financial Management Association International
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Financial Distress and Models
Restructuring
YehningChen,J. FredWestonand EdwardI.Altman
YehningChenis on thefaculty ofthe National Thispaperprovidesa synthesisof the theoretical literatureon financialdistress.It
Taiwan University,Taipei, Taiwan.J. Fred employsa two-stateframework, whichmoreclearlycapturesthegeneralizations of
Westonis ProfessorEmeritusRecalledat the the more complex models. The equationsystems that are derivedpermitthe
AndersonGraduateSchool of Management,
development of a seriesof examplesthatconveythelogicandintuitions behindthe
University of California, Los Angeles, CA. The illuminate of distress
not treated
Edward I. Altman is the Max L. Heine generalizations. graphicshelp aspects financial
Professor of Finance at the Stern School of
Theroleof riskis treated
inthepreviousliterature. explicitly.Alternativeassumptions
Business, New YorkUniversity,NY. generatedifferentpredictionsof the effects of financialdistresson investment
efficiencyandrestructuring strategy.Centralto thesestrategiesaretherecontracting
arrangements betweenowners,creditors,and otherrelevantstakeholders.The
resultingframeworkpermitsan evaluationof some centralprovisionsof the
prevailingU.S.bankruptcy laws.

N The basic social motivation for the legal, States, as well as to reform the bankruptcylaws of many
bankruptcy-reorganization process is to preserve othercountries.Issues of legal reformhave been analyzedby
organization value. One of the primary purposes of Adler (1992), Bebchuk (1988), Bradley and Rosenzweig
bankruptcylaw is to facilitatethe restructuringof financially (1992), and Roe (1983), among others.1 These reform
distressed firms. The laws seek to provide a recontracting proposalshave been criticizedby Altman(1993a), Bhandari
process that enables firms to once again invest in and Weiss (1993), LoPucki (1992), Warren (1992), and
value-creatingopportunities.Or, where liquidationvalues Whitman(1993).2
are greaterthan the going-concernevaluation,firms should
be forced to liquidateor be sold to some otherentity where IIn general,these articlescriticizethe bankruptcy-reorganization
process in
thatit motivatesinefficientandcostly actionsby managersandis a process
this inequalityis reversed.Many issues in this recontracting thatimpedestheallocationof corporateresourcesto the highest-valueduser
process have been identified. Can the distress be removed of those assets. BradleyandRosenzweig (B-R), in particular,claim thatthe
distressedfirm'sproblemsare frequentlyendogenouslydetermined,chosen
and a positive going-concernvalue be re-established,or will
by managers,ratherthanimposeduponthemby such thingsas competition
liquidation result in a higher value? How can the and interest rates. They assert that managers have no real incentive to
interestsof the centralparties(owners, managers,creditors, maintainan adequateliquidassetbalanceto meet currentobligationsas long
as thereis the possibilityof a court-supervisedandprotectedreorganization
employees, and consumers) be balanced? What are the mechanismwherebyexisting managementwill likely remainin control.In
effects on securitypricesandclaimsof owners,creditors,and essence, creditorandotherstockholdercontractualagreementsareabridged
and violated in order to enhance manager welfare. Empirical tests are
otherstakeholders?
provided, albeit claimed to be seriously flawed by critics of B-R, which
In recent years, the legal rules for bankruptcy, attempt to show that stockholders and debtholders have received
reorganization,and otherrecontractingprocesses have been significantly lower returns under the new 1978 Bankruptcy Code as
reassessed. Proposals have been made to change the 1978 comparedto the priorbankruptcycode.
B-R advocate repealing the existing bankruptcycode (the Code) and
BankruptcyCode (or, indeed, to eliminate the Chapter 11 substitutinga processwherebysuccessive classes of claimants,startingfrom
reorganizationoption entirely),which prevails in the United the most junior stockholderinterestsand advancingthroughthe seniority
hierarchyto the most senior creditors,have the opportunityto pay off the
Thanksto PiotrJawien for computermodelingof the generalrelationships company'sunpaiddebtsorelse be eliminatedfromthe process.If thedefault
and to Stanley Block (Texas Christian University) for his constructive is not curedat any level, thenthe mostseniorcreditorclass wouldbe entitled
comments at the 24th AnnualFMA Meeting, St. Louis, Missouri,October to either run the firm and retainthe firm's equityposition, sell its equity to
outside investors,or liquidatethe firm's assets for their exclusive use. In
14, 1994. We also appreciatethe helpful commentsof Antonio Bernardo,
Michael Brennan,Bhagwan Chowdhry,Michael Darby,HarryDeAngelo, essence, theprocessinvolves a seriesof call optionswherethe exerciseprice
JonathanHowe, Richard Roll, Walter Torous, and Ivo Welch. We are is the outstandinginterestand/orprincipaldue. If the optionis notexercised,
that class passing on the option is totally eliminated thereby preserving
gratefulto the Alcoa Foundationand the Foundationof the LittonIndustries absolutepriority(B-R, p. 1047).
for their supportof the Research Programin Competitionand Business
Policy at AGSM, UCLA and to the supportof the NYU Salomon Center, 2Many of the articles that are critical of the B-R thesis contain legal,
StemrnSchool of Business. conceptual, and financial market arguments,which are too numerousto

Financial Management,Vol. 24, No. 2, Summer 1995, pages 57-75.

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58 FINANCIAL / SUMMER1995
MANAGEMENT

Some centralanalyticalissues raised by the bankruptcy I. GeneralFramework

process include: 1) the time in bankruptcy;2) the effects on
The literature depicts three major players in the
security prices preceding, during, and after the relevant
"bankruptcy announcement" date; 3) default losses; 4) financial distress game: the shareholders(equity holders),
applicationof absolutepriorityversusrelativepriorityrules; banks (more generally financial institutions), and public
5) managerial incentives and the effects on managerial debtholders. The literaturealigns the goals of managers
turnover and executive compensation; 6) the role of with those of the shareholders, an underlying
exchange offers; and 7) the performanceof the firm after assumptionthat focuses the analysis and that we follow.
emergingfrom bankruptcyproceedings.Ourunderstanding Banks (financial institutions) are defined as debtholders
of therelationshipsamongthese elementshas been advanced with whom the shareholderscan directly negotiate.Public
by the developmentof formalmodels of financialdistressby debtholders are assumedto be dispersedso thatnegotiation
Altman(1993b), BerkovitchandKim (1990), Brown,James, is not feasible. These are obviously arbitrarybut useful
andMooradian(1993), Bulow andShoven (1978), Diamond underlyingassumptions.Otherrelatedassumptionsare:
and Dybvig (1983), Franksand Torous(1989), Gertnerand 1) All partiesare risk neutral.
Scharfstein(1991), GiammarinoandNosal (1994), Hartand
2) Since management'sgoals are aligned with
Moore (1994), Heinkel and Zechner (1993), Jensen and
those of shareholders,managementseeks to
Meckling (1976), John (1993), Myers (1977), and Scott maximizethe welfareof shareholders.
(1981).3 Empiricalevidence has been gatheredon the issues
set forth.4 3) Managersand shareholdersprefermore
The theoreticalliteratureon financialdistressis couched investmentto less, otherthingsbeing equal.
in complex models. However, the underlyingconcepts are We adopt the definition of financial distress as the
straightforwardand can be conveyed by relatively simple conditionin which the liquidationvalue of the firm's assets,
models. Also, despite their apparent generality, the Y, is less thanthe total face value of creditorclaims, D.
predictionsof the theoreticalmodels are dependentupon Reflecting the theoretical literature, our evaluation
their underlying (explicit or implicit) assumptions or criteriaemphasizethe effects on investmentefficiency. We
postulates. This will be clear from our analysis. Our endorse this emphasis because of its importancefor the
discussion is organized into seven sections. Section I efficient allocation of resources and for economic
providesa generalframework.Section II develops base case performance.Equations(1), (2), and (3) provide a basis for
formulations.Section III examines how debt maturitycan analyzingthe efficiency of investmentactions or decisions:
affect investmentefficiency. Section IV allows the firm to
alterthe seniorityof its claims holders. Section V analyzes NPV = PbXb+ PgXg - I (1)
the role of exchange offers. Section VI introducesfinancial
intermediariesinto the bankruptcyprocess. Section VII RSH = Pbmax[Xb-(1 - q)D,0] + Pgmax[Xg-(1 - q)D,0]
develops severalimportantimplicationsconcerninghow the - (I - Y) - qD = Vs (2)
bankruptcyprocess should operate. Section VIII furnishes
RDH = qD + Pbmin[Xb,(1- q)D]
concludingremarks.
+P - - - (3)
review here. Othersemphasizethe empiricalflaws of theirpaper,including min[Xg,(1 q)D] Y = (VD Y)
Altman (1993) and LoPucki's (1993) concern with the seniority-biased
natureof the sampleof bondsin thepre-Codeperiod(moresenior)compared where
to the post-Code(more subordinated)period.Altman(1993) and Bhandari
and Weiss (1993) find contraevidence and conclude that the increasein NPV = net presentvalue
filings in the post-1978 periodwas primarilydue to the change in corporate Pb = probabilityof bad state
leverage and reduced profitabilityand was not the consequence of the
change in law and its abuses. Altman also conducts extensive tests on Pg = probabilityof good state
bondholderreturns,controllingfor both seniority and credit quality, and
concludes that the B-R results are suspect. And for the assertion that Xb = in bad state
retumrn
managersgain from Chapter11, Gilson (1989 and 1990) finds thatthey do retumin good state
not fare very well in termsof job retentionand salary. Xg =
3Anumberof theseworkswill be reviewedin detailin the body of this paper. I = investmentoutlay
4Betker(1995a)calculatessecurityreturnlosses to bondholders(34%)and RSH = returnto shareholders,if the investment
to shareholders(40%).Recent empiricalstudieson the post-reorganization
is made
performanceof Chapter 11 firms consider both the average operating
performance(Hotchkiss,1995) andthe restructuredfirms' ex-post leverage q = ratioof short-termdebt to total debt
(Gilson, 1994). Both studies find that the reorganized firms perform
relativelypoorly and imply thatthe process can be improved. D = face value of debt outstanding

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CHEN,WESTON&ALTMAN/ FINANCIAL
DISTRESSAND RESTRUCTURING
MODELS 59

Table 1. Criteria for Investment Decisions

of positiveandnegativechangesin NPV,RSH,andRDHdefinefourtypesof investment

Combinations actions(see Figure1).

OperatingPerformance Changes in MarketValues

Returnto Returnto
NPV Shareholders (RSH) Debtholders (RDH) Investment Decision
(+) (+) (+, -) EfficientInvestment
(+) (-) (+) Underinvestment
(-) (+) (-) Overinvestment
(-) (-) (+, -) Efficient Noninvestment

Y = liquidationvalue of the firm's assets = LD, the outcomesin thebadstateandthegood state,respectively.

also the value of debt if the investmentis Similarly,Xb and Xg are the outcomes in the bad and good
not made states. The following balance sheet illustratesthe situation
Vs = marketvalue of equity facing a firm in financialdistress.
VD = marketvalue of debt, if the investment XYZCompany Balance Sheet I
is made LiquidAssets(Y) $70 Debt(D) $100
RDH = returnto debtholders,if the investment Equity (30)
is made = (VD - Y) The balance sheet shows thatthe firm has debt claims of
The logic of this equationsystem follows basic finance $100 and assets with a liquidationvalue of $70. The book
concepts.Expectedvalues areunderstoodthroughout,so the value of equity is negative $30.6
expectation operatoris omitted. Our base case analysis is In addition,we postulatethat the firm has an investment
facilitatedby assumingthatall debtis long-termandpublicly
opportunityrequiringan outlayof $80. The firmwould have
held so that in our equationsystem q dropsout.5Since both to raise$10 of additionalfundssince its
liquidassetsareonly
NPV and the risk of a projectaffect the decision to invest,
$70. In this specific example,the equationsystem becomes:
we also considerthe role of risk.
NPV = 0.5Xb + 0.5Xg - $80 (lb)
II. Base Case Formulations RSH = 0.5max[(Xb-$100),0] + 0.5max[(X - $100),0]
With q = 0, the resulting system is shown in Equations - ($80- $70) (2b)
(l a), (2a), and (3a).
RDH = 0.5min[Xb,$100]+ 0.5min[Xg,$100]
NPV = PbXb+ PgXg- I (la) -Y (3b)

RSH = Pbmax[(Xb- D),0] + Pgmax[(Xg- D),0] For a range of values of Xb and Xg, we use the above
- (I - Y) = Vs (2a) equationsand the criteriain Table 1 to define four types of
investmentdecisions. The operatingperformancecan result
RDH = Pbmin[Xb,D]+ P min[X ,D] - Y (3a) in either a
negative-NPV or positive-NPV project. The
The NPV equation does not change because it is results of the operating performanceof the firm will be
unaffectedby financing.In the most generalcase, an infinite reflected in the changes in the market value of financial
number of alternativefuture states of the world could be claims, equivalent to returns to shareholders(RSH) and
analyzed with continuous probability distributions. The returnsto debtholders(RDH). Combinationsof positive and
results of the formalmodels using continuousdistributions negative changes in NPV, RSH, and RDH define four types
are capturedand can be conveyed more easily by assuming of investmentactions,which are shown in Table 1.
a two-stateworld characterizedby eithera good outcome or Set Equations (lb), (2b), and (3b) equal to zero. In
a badoutcome.Thus,PbandPg arethe equalprobabilitiesof Equation(3b), VD is equal to Y. Since Y is the value of the

5Differentvalues of q are reintroducedin Section III, which analyzes the 6Its market value would be positive because, in some future states, the
effect of debt maturityon the efficiency of investmentdecisions. equity's call option to take over the firm has value.

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60 FINANCIAL / SUMMER1995
MANAGEMENT

Figure 1. Isolines for Characterizing Investment Decisions

200

120

Under
co00nvestment
, SH=0q0

so 0,bvEfficient
nvestment
,I S*2a

60
NPV=0
*4b

40 '
04a

No Investment lb

Over
Investment
0 20 40 60 80 100 120 140 160 180 200

cash flowin good state (X0)

debt if the investment is not made and the firm is required is $80, and there is only $70 of liquid assets
liquidated, it is a critical benchmarkfor determiningthe available.Since the gross presentvalue of cash inflows from
return to debtholders. The isolines for NPV = 0, RSH = the investment is $90, and the claim of the creditors is
0, andRDH = O0,(VD = Y) are graphed in Figure 1. Since $100, with perfect "me-first" rules or absolute priority,
the investment decision is made by the shareholders,the debtholders would receive the entire $90 and the equity
RSH = 0 and the NPV = 0 lines define the four types of holders would receive nothing.Assuming no divergenceof
investment action shown in Figure 1. interests between equity holders, old or new, we can treat
Table 2 providesvalues of Xb andXg to illustrateaspects them as the same party.7Since the equity holderswould be
of the fourtypes of investmentactionsshown in Figure 1. In unwilling to make a $10 equity investmentand receive no
Example la, NPV and RSH are both positive, so point la return,one form of underinvestmentoccurs.
unambiguouslyfalls in the efficient investmentregion. In Indeed,most firms that are insolvent and restructure,do
Example lb, RDH is negative. But since the shareholders so by attemptingto sell assets ratherthan investing in new
make the decision, the investmentis made because RSH is ones. The assumptionsof certaintyand risk neutralityare
positive. Since NPV is also positive, the investment is criticalto Myers' case. With uncertainreturns,the expected
efficient. NPV could be negative, but some outcomes may be
In Example 2a, RSH is negative. Even though NPV and sufficientlyhigh to yield positive returnsto equity.
RDH are both positive, the investment will not be made, This suggestsExample3 in whichoverinvestmentoccurs.
which represents an underinvestmentcase. Example 2b The returnto shareholdersis positive, but the NPV of the
illustratesthe Myers (1977) model undercertaintyin which projectis negative. In Figure 1, the returnto debtholdersis
underbothalternativestatesof the worldXb= Xg = $90. Our negativeas well. Nevertheless,investmenttakesplace.Thus,
frameworkenables us to convey the intuitionof this special
case. The firm has an investmentopportunityrequiringan
outlay of $80 with a gross presentvalue of $90. Hence, the 7This assumptionis not critical. An alternativeassumptionthat provides
identicalresults is thatnew sharesare fairly pricedin the marketsuch that
net presentvalue (NPV) of theprojectis $10. The firmwould the expected returnto new equity holdersis 0. For simplicity, we assume
haveto raise$10 fromnew equitysince the investmentoutlay thereis no divergenceof interestsbetween old and new equity holders.

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CHEN,WESTON&ALTMAN/ FINANCIAL
DISTRESSAND RESTRUCTURING
MODELS 61

Table2. Illustrationsof Testsof InvestmentEfficiency

Variousexamplesillustratehow investmentefficiencycan vary.Valueswere calculatedusing selectedvalues of Xb and Xg in

thefollowingequations:

(lb) NPV = 0.5Xb + 0.5Xg - $80

(2b) RSH = 0.5max[(Xb- $100),0] + 0.5max[(Xg- $100),0] - ($80 - $70)
(3b) RDH = 0.5min[Xb,$100]+ 0.5min[Xg,$100]- Y
RDH
Example Xb Xg NPV RSH (VD- LD) Investment Decision
la 60 140 20 10 10 EfficientInvestment
lb 30 140 5 10 -5 EfficientInvestment
2a 70 100 5 -10 15 Underinvestment
2b 90 90 10 -10 20 Underinvestment
3 20 130 -5 5 -10 Overinvestment
4a 40 80 -20 -10 -10 EfficientNoninvestment
4b 50 100 -5 -10 5 EfficientNoninvestment

the uncertaintyof the future cash flows may give rise to Result 1: By investing,shareholdersforce creditorsto sell
overinvestment. a call option below cost, giving rise to an overinvestment
The intuitionof thisresultis broughtoutby theillustrative problem.Moreover,from the propertiesof call options, we
numericalexamplewithinthe frameworkof the moregeneral know that shareholderswill prefer riskier projects, other
Figure 1. To make the investment, $10 has to be raised things being equal.
because I exceeds Y by that amount.In the bad state,when Nevertheless, if the shareholders "rolled the dice,"
the cash flow is $20, shareholdersreceivenothing.If the cash therebyjeopardizing the returnto debtholders,there exist
flow is $130, they receive $130 - 100 = $30. The expected outcomes thatwill be in the region of efficient investments.
payoff for new shareholdersis For example,the uppersection in the lower rightquadrantof
Figure 1 representsefficient investmentin which the retum
0.5($0) + 0.5($130 - $100) - $10 = $5 to debtholdersis negative. It correspondsto Example lb in
In this example, the expected value of the debt if the Table 2.
investmentis made(VD= $60) is less thanY, theliquidassets In areas4a and4b of Figure 1, investmentdoes not take
of the firm ($70). Y representsthe currentliquidationvalue place because both NPV and RSH are negative, which
of the firm and is also the value of the debt if the investment resultsfromthe low values of Xg andXb.Nevertheless,there
is not made.Hence the investmentcauses a loss (to creditors) is a segmentof this regionin which the returnto debtholders
of $10, reflecting the negative NPV of $5 from the is positive. This illustratesa situationin which shareholders
investment and the $5 gain on the underpricedoption that may efficiently forgo investmenteven thoughthe returnsto
accrues to the equity investors (at the expense of the debtholderswould be positive. Thus, efficient investment
creditors). may occurwhen the returnto debtholdersis negative,andan
The analyticsbehindthis result are based on the agency efficient noninvestment may occur when there would
problems related to the insight from the options have been a positive returnto debtholders.The examples in
literaturethat equity is a call option (Black and Scholes, Table 2 illustratethe natureof the fourregions in Figure 1.
1973, and Merton, 1973). By investing, shareholders Gertner-Scharfstein(1991, p. 1195) state that for the
receive an option to buy the firm at an exercise price pivotal lender to supply funds to restructuredebt and to
of $100 (face value of the debt). Obviously, the option is invest, NPV must be equal to or greaterthan(VD - LD), the
exercised when the cash flow is $130, because the value of returnto debtholders(RDH). This is somewhatmisleading
this option is positive: 0.5($130 - $100) = $15. However, since the above examples show that the effect on RDH is
shareholdersobtain this option by paying only $10. The irrelevantto the investment decision. Nevertheless, since
difference,$5, is a loss to creditors. NPV equals the sum of RSH and RDH, their inequality

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62 FINANCIAL
MANAGEMENT
/ SUMMER1995

implies a positive RSH as well as a positive NPV, the two More generally,for Xb = $0, and Pb= Pg = 0.5, we seek
conditionsrequiredfor efficient investment. a relationbetweenXg andD as depictedin Figure2. Equation
The Gertner-Scharfstein discussion is couched from the (2b') now becomes
viewpoint of "the bank," which they argueto be the likely
pivotal supplierof funds. In our view, it would be equally RSH = 0.5(X - D) - ($80 - 70) - [max($70 - D),0] 2 $0
plausible to postulate other alternative pivotal fund For D < Y, we have the declining left segment of the
suppliers. For example, trade creditors have a strong RSH = 0 line in Figure 2. It is
incentive to continue to ship goods to keep the debtor
firm a going concern. This helps preservethe value of their 0.5Xg - 0.5D - $10 - $70 + D = $0
existingclaims as well as to provideprofitsandcontributions
to overheadon continuing sales. In addition,suppliers are 0.5Xg = $80 - 0.5D
likely to understandthe business of their customersbetter Xg = $160 - D for D < Y
than banks, which lend to a wide variety of businesses.
For D 2 Y, we have the rising right segment of the
Furthermore,theircommon interestslead to the creationof
RSH = $0 line in Figure2. It is
groupsof creditorswith common interestswhose coalitions
facilitatenegotiation.But since the literaturetypicallyaligns RSH = 0.5(Xg - D) - max[(Y - D),0] - $10 = 0
the goals of the pivotal fund supplier with those of the for D > Y
existing shareholders, the analysis is performed more
directlyfrom the standpointof the existing shareholders. When D > Y, the max[(Y - D),0] termis always zero, so
we have
A. RelationshipbetweenY and D
Overinvestment or underinvestment may also occur 0.5(Xg- D)- $10 = 0
dependingupon the relationshipbetweenthe value of liquid or 0.5Xg -0.5D - $10 = 0
assets, Y, and the face value of debt, D.8 The general =
Xg $20 + D
expression for the returnto shareholders'line (RSH) when
D may vary is Thus, as shown in Figure2, for a debtlevel between zero
and $140, the returnto shareholdersis positive, but NPV< 0
RSH = Pbmax[(Xb- D),0] + Pgmax[(Xg- D),0] so overinvestmenttakes place. At a debt level greaterthan
- (I - Y) - max[(Y - D),0] 2 0 (2b') $140, in the area of the triangleformed by RSH =0 and
NPV = 0, the returnto shareholdersis negative,butNPV > 0,
Therefore,equity holders will make the investment if and and underinvestmentoccurs.
only if the payoff from investing (RSH) exceeds the payoff Result 2: With uncertainfuturecash flows, the higherthe
-
from no investment,max[(Y D),0]. (D/Y) ratio (when D 2 Y), the greaterthe likelihood of an
= = =
For D $70, Y $70, and I $80, the requiredXg is overinvestment problem. With an out-of-the-money call
option, shareholderscannotlose more. Figure 2 also shows
0.5(Xg- $70)- ($80- 70)- ($70- 70) = $0 that with extremelyhigh D/Y ratios, shareholdersmay feel
0.5Xg - $35 - $10 = $0 it not worthwhileto even makethe effortto invest, resulting
in underinvestment.
0.5Xg = $45 An example of overinvestment was the purchase of
Xg
= $90 Eastern Airlines by ContinentalAirlines thatoccurredsoon
after Continentalemerged from Chapter 11 in 1986. This
Thus, at a cash flow in the good state(Xg) of $90, the return gambleturnedout to be a disasterfor boththe equityholders
to shareholderswould be zero (actually, a small positive and creditorsof Continentalas the merged entity faltered.
amount) so that investmentwould take place even though Eastern Airlines went bankruptin 1989 and eventually
NPV would be less than zero at an Xg = $90. This amount liquidated,and Continentalfiled for Chapter11 once again
determinesthe low point of the RSH = 0 curve in Figure2. in 1990.9

9For a discussion of multiple Chapter 11 filings (sometimes called

8Thanksto JonathanHowe for this generalization. Chapter22s), see Altman(1993b).

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 DISTRESSAND RESTRUCTURING
CHEN,WESTON&ALTMAN/ FINANCIAL MODELS 63

Figure2. RelationBetweenDebtLevelsand EfficientInvestment

250

EfficientInvestment
2 200
RSH= 0

-o Underinvestment
o- NPV=0
150
SOverinvestment
RSH = 0

100

No Investment

50

0
0 50oDebt Y 70 100 140 150 2Oo

4 - Solvency 4 Insolvency
-

B. Return-Risk Framework standarddeviation of the retums for each combinationof

We next address the role of risk, measured as the outcomes.
These data are graphedin Figure 3. The expected return
variability of project cash flows. Because equity is a call
to shareholdersincreases with the level of risk while the
option, the largerthe risk of the project,the largerthe value
of the option,andthereforethe morelikely thatshareholders expected returnto debtholdersdecreases with the level of
risk. The intuition underlying Figure 3 results from the
will increasethe riskinessof its projectportfolio.Thatis, if
the investmentprojectis riskier,it is morelikely thatthe firm recognitionthatlow standarddeviationsare associatedwith
would invest (and thereforeit is more likely the firmwould relatively equal returnsin both states of the world. Hence,
debtholdersreceive a high percentage of their claims in
have an overinvestmentproblem).We, therefore,analyzethe
the bad state when the standarddeviation of retums is
expectedreturn(expectedNPV) in relationto risk. low. When the standard deviation of returns is high,
We againemploy the two-stateformulationto show how debtholdersexperience low returnsin the bad state relative
the expectedreturnto shareholdersrises with increasedrisk, to the good state. The returnsto the shareholdersincreaseas
as illustrated in Table 3. Columns (1) and (2) represent a consequence.
alternativecombinationsof cash flows in the bad and good Also, Table 3 illustrates that the sum of RSH and
states,respectively.Whenthe outcomesin bothstatesare80, RDH equals NPV. NPV in this example is zero since
the special case of certaintyresults since the outcome is the Pb = Pg = 0.5 and gross presentvalue and I areboth always
sameforeitherpossible state.The 0,160 combinationreflects 80. WithNPV = 0, RSH and RDH must be of equalabsolute
the greatestuncertaintysince the standarddeviation of the magnitudebut of opposite signs.
differencebetween the two returnswould be the largestfor In the precedingexample, NPV is held constant while
this combination.Columns (3) and (4) presentcalculations RSH andRDH varywiththe level of risk.Next, we hold RSH
of the returnto shareholdersand the returnto debtholders constantin orderto investigate the influence of risk on the
using Equations (2b) and (3b). Column (5) contains the requiredNPV. We employ the following definitions:

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64 FINANCIAL
MANAGEMENT
/ SUMMER1995

Table3. Calculationof the StandardDeviationof OutcomesWhenNPV = 0

deviationof returnsis calculatedforvariouspairsof possibleoutcomes(Xb,Xg)whenNPV= 0.

Thestandard

(1) (2) (3) (4) (5)

Xb X, RSH RDH Std. Dev. (X)
0 160 20.0 -20.0 80
5 155 17.5 -17.5 75
10 150 15.0 -15.0 70
15 145 12.5 -12.5 65
20 140 10.0 -10.0 60
25 135 7.5 -7.5 55
30 130 5.0 -5.0 50
35 125 2.5 -2.5 45
40 120 0 0 40
45 115 -2.5 2.5 35
50 110 -5.0 5.0 30
55 105 -7.5 7.5 25
60 100 -10.0 10.0 20
65 95 -10.0 10.0 15
70 90 -10.0 10.0 10
75 85 -10.0 10.0 5
80 80 -10.0 10.0 0

V +e Xb = V-e
- area have a positive NPV but a negative RSH. In the
g
Xg= overinvestment area, RSH is positive, but the NPV is
where V and e are positive parameters. Under these
negative.
assumptions,the gross presentvalue (PgXg+ PbXb) of the Thus, we have demonstratedthe role of risk in relationto
projectis V (so NPV = V - I), and the standarderrorof the NPV and RSH. Next, we considerthe role of debt maturity.
presentvalue is e.
In Table 4, we select combinationsof Xg and Xb that
Ill. Influenceof Debt Maturity
satisfythe abovedefinitions.We can also verify thattheNPV
values satisfy Equation(la) whereinvestmentis equalto 80. The role of debt maturity is analyzed assuming two
Forexample,when XbandXg sum to 180, the expectedGPV periods,denoted1 and2. Thefinanciallydistressedcondition
is 90 so NPV = 10. Using Equation(2a), RSH will be zero. of the firm is still as depicted by Balance Sheet I. The firm
RDH will decline as shown in Table 4. has public debt totaling $100. Debt maturity is now
These results are displayed in Figure 4. The intuition introducedwith the ratio of short-termdebt to total debt
defined as q, with 0 ? q ? 1.10 Short-termdebt maturesat
underlyingthe RSH = 0 line is thatwith increasingrisk (the
date 1, before the investment is made; long-term debt
possibility of really high returnsin the good state),the NPV
maturesat date 2, afterthe cash flows from the investment
requiredto induceequityholdersto makethe new investment
is lower. Also, as shown in Table 5 for NPV = 30, for any are realized.The outcomeof the investmentis uncertain.In
constantlevel of NPV, RSH will rise with the level of risk the bad state of the world, the cash flow is $20; in the good
and RDH will decline. state, the cash flow is $Xg.11
Four regions of investment action are defined by the
NPV = 0 andRSH = 0 lines in Figure4. These four regions r1This is the same symbol Gertner-Scharfstein(1991) chose; it has no
relationto Tobin's q.
in risk, NPV space parallel the four regions defined in I'The cash flow assumptionsare chosen to illustratebetterthe principles
Figure 1 in Xg, Xb space. Points in the underinvestment involved.

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 DISTRESSAND RESTRUCTURING
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Figure3. ExpectedReturnsin Relationto Risk WhenNPV= 0

20 -- RSH
15
10

5-

0-
10 20
FM
30 0 40
' 50 60 70 40 NPV:0

-10

-15 --
-20 VD - LD
StandardDeviationof CashFlows(e)

Table4. Coordinatesfor RSH = 0 in Risk,NPVSpace

howNPVandRDHvarywiththelevelof risk(e) whileRSHis heldconstant.

Variousexamplesillustrate

Xb e = Std. Dev. NPV RDH

Xg
110 110 0 30 30
100 120 10 30 30
60 120 30 10 10
40 120 40 0 0
20 120 50 -10 -10
0 120 60 -20 -20

We calculate the efficient investment criterion using Equations(lb), (2b), and (3b) but with a differentassumed
Equation(1). The NPV of the projectis Xb. The firm can use the liquid assets ($70) to finance part
of the project.It still needs to raise an additional$10 (from
NPV = 0.5Xg + 0.5($20) - $80 = 0.5Xg - $70
the old shareholders).At date 2, the amountof public debt
If the investmentdecision is efficient, the investmentshould due is $100. If cash flow Xb is $20, shareholdersreceive
be made if NPV is greaterthan $0, or Xg 2 $140. This will nothing (and creditorsreceive $20). If the cash flow is $Xg,
be ourpoint of referencefor the requiredlevel of an efficient shareholders receive Xg - $100. Hence the gain to
investment.In the following analysis,we vary the value of q shareholdersis
to illustratethe role of debt maturity.
0.5(Xg - $100) + 0.5($0) - $10 = 0.5Xg - $60
A. All Debt Is Long-Term
In Case IIIA, we assume thatq = 0, so the entire$100 of Shareholderswill makethe investmentif 0.5Xg - $60 2 0, or
debt is long-term. This is equivalent to our base case Xg ? $120. Since the required Xg under the efficient

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66 FINANCIALMANAGEMENT/ SUMMER 1995

Figure 4. Characterizing Investment Decisions in Risk, NPV Space

Efficie...........n
O
RSH=............ O-,..............

g ,Efficient Investment

r:? :? :
-:? :? ?:
?..
~.:i..:i..::.....................':
~~i~i~i...
?....

~~ittir~rrr........................~t
....?:
?
.....: .. . . .I .. .. . ... . .. ... .
..................~iii

.
r:::::::::.........................::
::?:?:?;?:.. ......:
?
r~?:tiiir..........................''
-8 0 ~'' l' i
''..........................i
. .. .. . .

Table 5. Risk and Returns

howRSHandRDHvarywiththelevelof risk(e) whileNPVis heldconstant.

Variousexamplesillustrate

Xb e NPV RSH RDH

Xg
110 110 0 30 -5 30
100 120 10 30 0 30
80 140 30 30 10 20
60 160 50 30 20 10
40 180 70 30 30 0
20 200 90 30 40 -10
0 220 110 30 50 -20

investmentcriterionis $140, the firm has an overinvestment must raise: $100 + $80 - $70 = $110. In this example, we
problem. assume that the funds raised are equity, so that the firm
The reasonfor the overinvestmentis clear. Shareholders becomes an all-equity firm. If the investmentis made, then
can gamble using creditors' money. As before, if the in the bad state the cash flow is $20, and the shareholders
investmentis not made, creditorswill receive all the liquid receive $20 since all debt was short-termand had to be
assets. By using the liquid assets to finance the project, repaid.In the good state,the cash flow is $Xg. The expected
shareholdersreceive an underpricedoption. Therefore,the payoff to the shareholdersfrom making the investment,
problemis an overinvestmentone. using Equation(2), is
B. All Debt Is Short-Term 0.5Xg + 0.5($20) - $110 = 0.5Xg - $100
In Case IIIB,all debtis short-term(q = 1), so thatthe entire
-
$100 debt obligation has to be repaidbefore the investment Shareholderswill make the investmentif 0.5Xg $100 2 0,
is made.Therefore,to makethe investmentat date 1, the firm or Xg 2 $200. Comparedto the efficient investmentcriterion

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 DISTRESSAND RESTRUCTURING
CHEN,WESTON& ALTMAN/ FINANCIAL MODELS 67

of Xg 2 $140, the firmhas an underinvestmentproblem.The work out what they felt was a short-termproblemowing to
required Xg is much higher solely because of the debt's overleveraging a basically sound operating company.
maturity. Exchanges usually involve either a total exchange of
The NPV equation for the efficient investment is preferred and/or common equity for the old debt or a
NPV = 0.5Xg - 70. When the entire debt is short-term, combinationof some equity and some new, but extended,
NPV = 0.5Xg - 100, so the firm has to pay creditorsa $30 debt for the old debt.
differentialbefore it makes the investment.Since the good The classic distressed exchange involves a firm whose
stateoccurswithprobability0.5, theadditionalamountof Xg operatingandfinancialconditionhas deteriorateddueto both
requiredis $60. Therefore,the firm has an underinvestment chronicandcyclical problems.It attemptsto restructureboth
problem.If the firm must pay off a pre-existingdebt before its assets and its liabilities. For example, International
it can invest, the repaymentobligationeffectively serves as HarvesterCorporation,a large farm equipment,truck, and
a "tax," which causes an underinvestment problem. bus manufacturer,was on the verge of total collapse in
Alternatively,when the owners can exercise theiroption to 1980-1982. The firm first exchanged preferredstock for
buy out the creditorsat a cost below the value of the option, its interest payment obligations to banks and extended
there is a subsidy that gives rise to an overinvestment both its interest payments to creditors and payables to
problem suppliers.Next, it convertedits short-termbank debt (1-3
Result 3: The maturity structure of debt influences years) to longer term "junk" bonds (10-12 years).
investment efficiency. The shorter the maturity structure Finally, it exchanged common equity in its newly named
of debt, the more likely it is the firm will have an entity, Navistar International,for the "old" junk bonds.
underinvestmentproblem.Since the equity is a call option, These distressed restructuringstrategies helped the firm
reducingdebt maturityis equivalentto reducing"time" in recover;it eventuallypaid its short-and long-termcreditors
the Black-Scholes option valuationmodel. The value of the in full.14
option decreases, which reduces the incentive to invest
unless even riskier prospects are available. The longer the D. Debt Maturityfor EfficientInvestment
maturitystructureof the debt, the more likely it is the firm In the two previous examples, we illustrated the
will have an overinvestmentproblem.The value of theequity extreme cases of q = 0 and q = 1. Case IIIC calculates a
call option in thatcase increases. value of q that eliminates both the overinvestmentand
underinvestmentproblems. For example, if q = 0.2, the
C. Restructuring the Debt Maturity amountof short-termpublic debt is $20, and the amountof
The underinvestmentproblemillustratedin the preceding long-termpublic debt is $80.
example can be mitigated,or even eliminated,by adopting To financethe investment,the firmuses liquidassetsplus
strategiesfor alteringthe liability term structure,known as $10 of new equity.It also has to raise$20 of additionalequity
distressed extensions or exchanges. Extension results in a to pay off the short-termdebt.Since the $30 of new financing
lengthening of the maturity of all or a portion of the is equity,at date 2, the amountof debt due is $80. If the cash
debt so as to enhance the probabilityof repaymentand to flow is $20, the shareholders receive nothing, and the
enable the firm to avoid the higher cost of a Chapter 11 public debtholdersreceive $20. If the cash flow is $Xg,
reorganization.12 In our case, the additionalfundsneeded to shareholdersreceive $Xg - $80. Using Equation (2), the
make the investmentare reducedby the amountof the debt shareholders'returnfrom investingis
repaymentthatis deferred.13
Exchangestypicallyresultin substitutingequityfor debt. 0.5($0) + 0.5(Xg - $80) - $30 = 0.5Xg - $70
Distressedexchangeshave been widely used in recentyears
by firms that issued high-yield "junk" bonds and tried to Shareholderswill invest if 0.5Xg - $70 2 $0, or Xg 2 $140.
The investment decision in this case is efficient. There is
12A number of studies have compared the out-of-court restructuring
neither an overinvestmentnor an underinvestmentproblem.
arrangementwith the more formalChapter11 procedure.All such studies,
e.g., FranksandTorous and
(1989), Gilson,John, Lang(1990), andHelwege Result 4: Ourdemonstrationthatit is possible to choose
(1995), concludethatout-of-courtarrangements,usuallyexchanges,areless a q (a maturitystructureof the debt)thatwill enable the firm
costly when they are successful. However, often the attemptto restructure
is not successful, and Chapter11 is merely postponed. 141naddition,and perhapsmost important,InternationalHarvestersold its
13Ofcourse, if the short-termdebt can be "rolled-over,"the debt maturity farmequipmentdivision. The cash proceeds, when combinedwith the cash
is effectively extended.Healthyfirms do this routinely,but it is much less flow savings from the debt rescheduling, enabled it to invest in plant
common in situationsof financialdistress. modernizationand develop new models of trucksand buses.

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68 FINANCIAL / SUMMER1995
MANAGEMENT

Figure5. RSHand RDHUnderVaryingq

20 -

cc

Cu ?

1oSH f
VNPVIX

40I

20

rRS.
0- -

0 20 40 80 1 120 J140 60 180 2C0

cash flowin good state (X,)

"0

to make an efficient investment decision suggests another below the liquidationvalueof thefirm,Y, which thecreditors
relationship.Recall the basic assumptionthat the cash or could have realized.15
liquid assets of the firm, Y, are less than the face value of Figure5 illustratesthatthe VD = Y line and the RSH = 0
total debt. If $X (cash flows from the investment)is subject line both shift as q changes.When q increasesfrom 0 to 0.2
to greater uncertainty (leading to an overinvestment (short-termdebt goes from 0 to 20% of total debt), the
problem), raising q (more short-term debt) creates an intersectionof the three decision lines shifts. The VD = Y
offsetting underinvestmenttendencythatresultsin efficient line shifts downwardas q increases. This results from the
investment.If $X is subjectto lower uncertainty(leadingto debtholders receiving more up front in the form of the
an underinvestmentproblem),lowering q (more long-term short-term debt that has to be repaid before the
debt) creates an offsetting overinvestmenttendency that investment is made. Hence they can accept a lower cash
results in efficient investment. flow in the bad state and providemore for the shareholders
in the good state. The RSH = 0 line shifts to the right as q
E. Toward Generalizations increases.Shareholdersmust now receive a higherreturnin
The examples convey the basic intuitionconcerningthe the good stateto offset the tax thatmustbe paid to retirethe
influence of debt maturityon the investment decisions of short-termdebt as a conditionfor makingthe investment.
distressedfirms. The generalrelationshipsareconveyed by Another example will reinforce these general relations.
Equations(1), (2), and (3), which include the effect of debt Table 6 illustratesthe effects of a high value of q. Table 6
maturity.Equation(3) makes explicit the requirementthat uses a q = 0.9, implying that most of the debt is short-term
the value of the debt, if the investmentis made, mustnot fall andresultingin a largetax up front.The NPV is positive,but

illustrateswhetherequityholderscan takeadvantageof debtholders.Inmost

15Ina formal Chapter11 proceeding,this relationshipconforms with the cases, adequateprotectionresultsin attractivereturnsto the debtholder.For
concept of "adequate protection," which "guarantees" certain secured example, the creditorswho owned Youngstown Sheet & Tube's secured
creditorscompensationat least equalto thevalue of the collateralat the time bonds in the parentcompany's (LTV Corp.)bankruptcydid extremelywell
of the claim confirmation-usually shortlyafterthe bankruptcypetitionis despite a long and costly reorganization.Unlike the EasternAirlines case,
filed. If the reorganizationis not successful and the liquidationvalue falls the extendedChapter11proceedingof LTV did not negativelyimpactthose
below the amountof adequateprotection,then indeedthese creditorswould creditorswho were adequatelyprotected.In an out-of-courtrestructuring,it
have been betteroff with liquidationat an earlierdate. This conformsto the is possible undercertaincircumstancesfor this inequality to be justified,
overinvestmentsector in Figure 1. Therefore,the VD = Y line in Figure 1 as demonstratedby Kahane and Tuckman(1993).

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 DISTRESSAND RESTRUCTURING
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Table6. Illustrationof the Effectof Highq

A highvaluefor q tendsto createan underinvestment

problembecauseof the largeup-front"tax"thefirmmustpay whenit retires
short-term
debt.
IIIC
,Case
Xb = $20

Xg = $150

q = 0.9

NPV = 0.5($20)+ 0.5($150)- 80 = $5

RSH = 0.5($20- 10)+ 0.5($150- 10)- $80 + $70 - $90 = -$25

VD = $90 + 0.5($10)+ 0.5($10)= $100 ($30fromSH)

the RSH becomes negative. The marketvalue of the debt seniorto the old debt, if the cash flow in thebad state is $20,
rises from $70 to $100. The $30 increase in VD represents the shareholdersreceive $20 when the new debt is repaid.
what is takenfrom the shareholders. The returnto shareholdersfrom investing is
The effects of debt maturitycan also be illustratedwithin
the frameworkof therisk-returnexample.Table7 andFigure RSH = 0.5($20) + 0.5(Xg - $80) - $30 = 0.5Xg - $60
6 illustratethe sensitivityto q of the relationshipbetweenrisk
andretumto the securityholders.Figure6 shows thatraising Shareholderswill invest if 0.5Xg - $60 ? 0, or Xg 2 $120
q shifts the RSH line downwardand shifts the RDH line (versus $140 for efficient investment).Now the firm has an
upward. overinvestmentproblem.By manipulatingthe seniorityof its
debt (more long-term relative to short-term),shareholders
IV. Shifted PriorityPositions gain at the expense of public debtholders.Therefore,they
have more incentiveto invest.
In the previouscase, we assumedthatthe firm raises the
The creationof new debtwith a seniorityor super-priority
requiredfunds by issuing equity (to old shareholders).An statusvis-a-vis old debtis theprimefactorthathas stimulated
implicationof this assumptionis thatexisting publicly held the growth and importanceof debtor-in-possession(DIP)
debt has a higher seniority than the new (equity) security
issued. financing. DIP financing, supplied primarilyby banks and
financecompanies,is used to provideneededinvestmentand
In Case IV, we assumethe firmissues new debtto obtain
the requiredfunds.We also assumethatexisting debtcarries working capital funds to firms that have just filed for
no covenantsto protectits priorityposition, so thatthe firm Chapter11 protection.It has been criticalto the success of
is able to give the new debt a seniorpriorityposition. When many formal in-court restructurings.16The super-priority
status of the new debt need only be sanctioned by the
the firm is able to grantseniorityto the new debt, it is more
bankruptcyjudge, which obviatesthe need for prior-creditor
likely to make the investment.
Case IV illustratesthe effect of assigning senior priority approval.An out-of-courtrestructuringthat involves new
to the new debt. It again assumes an efficient debt maturity debt being given priorityover old debt, on the other hand,
structurein which q is equal to 0.2. As before, the firm has requires virtually 100% creditor approval and is very
difficult to obtain.
liquid assets of $70, and the requiredinvestmentoutlay is
$80. To make the investment, the firm needs to raise an Result 5: The greaterthe firm's abilityto manipulatethe
additional $10 for the investment and $20 to repay the position of its claimholders, the more the firm can take
maturingshort-termdebt. Therefore,at date 2, the firm has advantage of debtholders whose priority position is
$30 of new debt and $80 of existing long-termdebt. If the unprotected. This highlights the importance of bond
cash flow from the projectis $X, all debt is repaidin full, so covenants. Furthermore,when the firm has the power to
that the old shareholders receive $X - $80 (the old
16See Chapter4 of Altman(1993b) for a discussion of DIP financing.These
shareholdershold the $30 new debt). Since the new debt is loans, in additionto theirsuper-prioritystatus,are usually also secured.

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70 FINANCIAL
MANAGEMENT
/ SUMMER1995

Table7. Risk-ReturnRelationshipsfor AlternativeMaturityStructures

The maturitystructureof the firm's debt, as proxiedby q, altersthe relationship

betweenrisk and returnfor both debtholders
andequityholders.

Xb Xg
NPV RSH,q = 0 E(X) Std. Dev. (X) RDH,q = 0 RSH,q = 0.2 RDH,q = 0.2
0 160 0 20.0 80 80 -20.0 10.0 -10.0
5 155 0 17.5 80 75 -17.5 7.5 -7.5
10 150 0 15.0 80 70 -15.0 5.0 -5.0
15 145 0 12.5 80 65 -12.5 2.5 -2.5
20 140 0 10.0 80 60 -10.0 0 0
25 135 0 7.5 80 55 -7.5 -2.5 2.5
30 130 0 5.0 80 50 -5.0 -5.0 5.0
35 125 0 2.5 80 45 -2.5 -7.5 7.5
40 120 0 0 80 40 0 -10.0 10.0
45 115 0 -2.5 80 35 2.5 -12.5 12.5
50 110 0 -5.0 80 30 5.0 -15.0 15.0
55 105 0 -7.5 80 25 7.5 -17.5 17.5
60 100 0 -10.0 80 20 10 -20.0 20.0
65 95 0 -10.0 80 15 10 -22.5 22.5
70 90 0 -10.0 80 10 10 -25.0 25.0
75 85 0 -10.0 80 5 10 -27.5 27.5
80 80 0 -10.0 80 0 10 -30.0 30.0

manipulateseniority, the overinvestmentproblem is likely cash flow of $130. The firm makes an unconditional
to be more severe.17 exchange offer to the public creditors.Initially, we assume
there is no short-termdebt and that all debt matures in
V. Analysisof ExchangeOffers period2.
The face value of the debtis $100. It is held equallyby 10
When the presentvalue of the firm's assets is less thanits creditors,andthese creditorscannotcoordinatetheiractions.
liabilities, an out-of-court exchange offer is considered a All debtis long-term.It maturesafterthe cash flow fromthe
"distressed" restructuring.18Case V analyzes exchange investment is realized. The firm makes an unconditional
offers. It retainsall of the previousassumptionsexcept that offer to the public debtholdersto exchange $10 of old debt
it assumes thatthe firm has sufficient liquid assets ($80) to for $8 of new debt. The new debt will be senior to any
cover the cost of the investmentproject. Thus, one of the remaining, nonexchanged old debt whereas it now ranks
complicating elements of the cash flows is removed to paripassu with all the otherdebt(a very criticalassumption).
simplify the analysis.To analyzethe payoffs to a creditorto Two issues are posed. If each creditorbelieves that all the
whom an exchange offer is made, we assume a 0.5 others will tender, will the exchange offer be successful?
probabilityof a cash flow of $50 and a 0.5 probabilityof a After the exchangeoffer, are creditorsbetteroff or not?
Table 8 shows the payoff table for an individual
17Althoughthe guidingprincipleof distressedrestructuringis the so-called
debtholder underthe above assumptions.We first consider
absoluteprioritydoctrine,it has been estimatedby manyresearchersthatas the position of a creditorwho decides to hold out.19For the
manyas 75%of reorganizationsresultin violationsof absolutepriority.Still, nine otherswho tender,the face value of the new debtis $72.
theseviolationsarenotmaterial,andseniorityreallydoes providesignificant
investorprotection.See Altmanand Eberhart(1994). If the cash flow is $130, $58 is available to pay off the
18Publicunsecureddebt that is "distressed"typically sells in the range of
50% to 70% of par value. The exchange is treatedas a default by market 19Bernardo(1995) presents a generalized treatmentof exchange offers
practitionersand other analysts (e.g., see MerrillLynch (1994) for default analyzedin termsof symmetricNash equilibria.He specifies the conditions
statistics on high-yield debt where defaults include distressed thatsupporta symmetrictenderingequilibriumas well as the conditionsthat
restructurings). supporta symmetricholdoutequilibrium.

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CHEN,WESTON&ALTMAN/ FINANCIAL
DISTRESSAND RESTRUCTURING
MODELS 71

Figure6. ReturnsUnderNPV = 0, and q = 0, q = 0.2

30

20 C RSH, q=.0

10 RSH,q=.2
10
a 10 20 40 60 80
-10 RDH, q=.2

-20 - RDH, q=0

-30
StandardDeviationof CashFlows

Table8. Payoffto a Creditor

Cash Flows (Probability)

$130 (0.5) $50 (0.5) Expected Payoff

Action of Tender $8 $5 0.5(8) +0.5(5) = $6.5

the Creditor Hold Out $10 $0 0.5(10) + 0.5(0) = $5.0

hold-outcreditorin full, $10. If the unfavorablestateoccurs, and that they think that all others will tender, tendering
the $50 is not sufficientto cover the seniorclaimsof the nine dominatesholding out. Gertner-Scharfstein(1991) call this
creditorswho tendered,and the payoff to the hold-out, now phenomenona "hold-in" problem.
a juniorcreditor,would be zero. Mooradian(1994) extendsthis analysis.He observesthat
We next consider the tenderalternativefor an individual with a single creditor there is no coordination problem
creditor.The face value of the new debtwould become $80. of the type discussed above. He also analyzes the role of
In the favorable state, when the cash flow is $130, all asymmetric information in a model of public debt
creditorsare paid in full, and each receives $8. If the cash restructurings.In the absence of Chapter11, an inefficient
flow is $50, each creditorreceives $5. As shown in Table 8, firm always mimics an efficient firm. As a consequence,
the expected payoff for tendering is larger. Hence, all either inefficient firms overinvest or efficient firms
creditorstender,and the offer succeeds. underinvest. But Mooradian observes that Chapter 11
The creditorsbecome worse off because of the exchange provides an incentive for an economically inefficient
offer. Withoutthe exchange offer, the expectedpayoff for a firm to reveal its condition because management
creditoris 0.5($10) + 0.5($5) = $7.5. On average,therefore, bargainson behalf of equity holders to preserve a valuable
each creditor loses $1 because of the offer. If creditors claim on the firm for them.
can work as a group, they will reject the offer.20However,
under the assumptions that creditors cannot coordinate VI. ExtensionswithFinancial
Intermediaries
20Seeourdiscussionin the next sectionconcerningtheincreasinglycommon
For the first set of cases, we assumedthatno "banks"are
developmentof organizedcreditorcommitteesrepresentedby sophisticated
distressedrestructuringspecialists. formally involved. Banks and other financial institutions

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72 FINANCIAL / SUMMER1995
MANAGEMENT

have several characteristics that distinguish them from 3) Thereis still both long-termand short-term
atomistic creditors: 1) They are better informed about the public debt. The variableq continuesto be
debtor; 2) they write debt contracts of relatively short defined as the ratioof short-termpublic debt
maturityto facilitatemonitoringand recontracting;3) they to total public debt.
are smaller in number, facilitating communication and In Case VI, we begin our analysisof the implicationsof
negotiation;and4) in practice,they generallyseek a priority the use of bankdebtby consideringtheextremecase in which
position.21 there is no public debt and the $100 debt is all bank debt.
In Gertner-Scharfstein(1991), the bank, unlike public Case VI differs from Case IIIB where q was equalto one in
debtholders,can negotiate with old shareholderscostlessly thatthe bankcan defer paymenton its claims due at date 1,
andmaximize the joint payoff to itself andthe shareholders. while in Case IIIB all of the short-termdebt had to be
Moreover, bank debt is always short-term (maturing at repaid before the investment could be made. The same
date 1). Unless thebankagreesto makeconcessions,thebank question arises:What is the lowest $Xg thatwill induce the
debt needs to be repaidbefore the investmentis made.22 bank to agree to restructurethe bank debt and finance the
If the firm can negotiate costlessly with "bank-type" new investment project? We also investigate whether the
lenders, there is no bargainingproblem. The parties will investmentis efficient.
functionaccordingto a Coase (1937) Theorem,which holds If the bank does not refinancethe firm and liquidation
that they will work as one party seeking to maximize occurs, the bankreceives $70, the value of the liquid assets.
investmentreturnsin theirjoint interest. On the otherhand,if the bank lends the firm the additional
In a bankdebtrestructuring,thebankextendsthematurity $10 and defers the maturityof the old bank debt to date 2,
of the old debt to date 2 and providesthe firm with the cash the amountof the bankdebt (principal)due at date 2 will be
necessary to make the investment and pay off short-term $110. (The bank was already owed $100 and loaned $10
publicdebt.The face valueof the new bankdebtwill be equal more.) Since the bank debt is the only debt and the bank
to the face value of the old bank debt plus the new loan. maximizes the joint welfare of itself and shareholders,we
Intereston new bank debt is allowed. If the bankrefuses to can treatthe firm as an all-equityfirm.Therefore,the bank's
refinancethe firm, the firm may try to get financing from expected payoff from bankdebt restructuringis
othersources.23If no othersourceis availableto financethe
project,the firm will be liquidatedat date 1. 0.5($20) + 0.5Xg - $10 2 $70
The basic assumptionsmade in the previous examples
with only public debtholdersaremaintained.Balance Sheet If Xg 2 $ 140, the projectwill be financed.24
I applies with liquid assets of $70 and total debt claims of The investmentdecision is efficient in this case. Since the
bank is the only source of debt financing, it seeks to
$100. The new projectrequiresan investmentof $80. The
cash flow in the bad stateis $20 and in the good stateis $Xg. maximizethe joint welfareof itself and the shareholders.In
The assumptionsabout the debt structure,however, are order to meet maturingobligations and finance the new
altered. investment,the bank does not face an extra "tax," which
would lead to underinvestment,andit does not receive a free
1) The firm has two types of debt, bankdebt and
option on the firm, which would lead to overinvestment.
public debt. The sum of the bankdebt and the Result 6: Whenthe principalamountsof all formsof debt
public debt is $100 (face value). have the same seniority (and interestis junior to principal),
2) All debt (old and new, bankand public) has the the higher the ratio of bank debt to total debt, the more
same priority.There is no interestpayableon old efficient is the investment decision. In the extreme case,
debt. The intereston the new debt is junior to the when all debt is bank debt, the investment decision is
principal. efficient.The logic of these resultsfollows fromtheprevious
analysis. Comparedto most public debt, the bank debt is
21Therationalefor this is set forthin Welch (1994).
22ArecentworkingpaperbyJames(1994) arguesthatbankdebtforgiveness
shorterterm. The overinvestmentproblemis reducedsince
can mitigateholdout and informationproblemsand increasethe chance of the underpricedoptionis not offeredto the sourceof the new
success of exchangeoffers. The bank,however,mustbe willing to go along financing.With the bankas the sourceof new financing,the
with the restructuringplan.
firm does not face the inflexible requirementof paying off
23Asnoted above, new debtfinancingafterthe Chapter11 filing is usually
given a super-prioritystatusover the old debt. The lendercan be eitherthe
old bankor an entirelynew financialinstitution.If the latteris the case, the 24If,however,therewas $20 of publicdebt due in period I and it could not
interestrateon the new debt is usuallyhigherthanif the originalbankwas be deferredto period2 withoutconsiderablecosts, then the projectwill be
the lender. financedonly if Xg 2 $180.

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CHEN,WESTON&ALTMAN/ FINANCIAL
DISTRESSAND RESTRUCTURING
MODELS 73

the short-termpublic debt (it avoids that "tax"), thereby or more classes of claimants may provide new or future
mitigatingthe underinvestmentproblem. financingas a basis for improvingtheirposition over whatit
would have been underabsolutepriority.2) Managersretain
VII. Some Implicationsfor considerablepower after a firm has filed for bankruptcy.
BankruptcyRules Managersare able to continue to make operatingdecisions,
and for 120 days afterthe Chapter11 filing, managershave
The foregoinganalysishas severalimportantimplications
the exclusive right to propose a reorganizationplan. The
regardinghow the bankruptcyprocess should operate.
court often grants one or more extensions of this deadline.
We begin with the automaticstayprovisionof Chapter11
has 180 days from the filing date to obtain
of the U.S. BankruptcyCode. An automaticstaypermitsthe Management
creditorand shareholderapproval.If a firm fails to propose
firm to stop all principaland interestpaymentsandprevents
a plan or its plan is rejected, creditors can propose their
securedcreditorsfrom takingpossession of theircollateral.
own plan. To do so, they must provide proof of values for
These creditors must be compensated, however, with
claims to be issued and assets to be retainedor sold. This
"adequate protection," which stipulates that, at the very
and hearings,as comparedwith a
least, they should receive the value of the collateralin any requirescostly appraisals
management plan that requires the bankruptcyjudge to
subsequentreorganization.This is equivalentto converting
evaluate it as "fair and reasonable."3) Estimatedmarket
all debt to a longer-term maturity. Other things being
values areused as a basis for establishingprioritypositions.
equal, when a firm is in financial distress (liquid assets
But marketvalues dependon the success of the restructuring
are less than debt claims), the automaticstay will increase
and the futureperformanceof the firm.The futurecannotbe
the firm's incentive to invest. The automatic stay
known with certainty,so thatthe imputedvalues are subject
strengthensthe position of the existing control group-the
to error and therefore subject to negotiation among the
debtor-in-possession(DIP). This makes it easier to obtain
claimants. Thus, deviations from absolute priority may
additionalfinancing.The possibility of DIP financingwith
facilitate approvalof a plan earlier than otherwise would
priorityover existing debt facilitatesnew investment.
be possible. Early emergence from the uncertainty of
The 1978 BankruptcyCode introducednew voting rules
will also have a positive influence
for approvalby creditorsof a reorganizationplan. The new bankruptcyproceedings
on investment.
Chapter11 specifies majority(in number)requirementsfor
Two relatively recent developments strengthen the
approvalof the plan andprovidesthatdissentersmust accept
of individualcreditors.The first is the aggressive
the same termsas approvedby the majority.25In this sense, position
of powerful, active investors who purchase a
eachclass of creditorsbehavesas one partyin whichminority strategies
controlling interestin a key class of claims in orderto block
creditors cannot hold out. The new voting rules facilitate
unpopularplans or to propose a plan that results either in
renegotiationof the debt so thatthe potentialfor investment
dramaticallybettertermsfor the creditoror even control of
efficiency is improvedby reducingbargainingcosts.
the company when it emerges from Chapter 11. A
The Code also provides for absolute priority rules in
well-known example of the latter is the role of Japonica
establishing the order of claims under reorganization.
Partners, creditors and equity infusers in the Allegheny
Frequent,but small (2.3 to 7.6%) deviations from absolute
International Corporation case, which achieved sole
priorityoccur. Some possible explanationsinclude: 1) One
ownership of the entity (Sunbeam-Oster)that was formed
25If the reorganization is proposed in an out-of-court distressed after Chapter 11. Successful examples of the former are
restructuring, i.e., not under Chapter 11, then a virtually unanimous the negotiation strategy of M.J. Whitman &
acceptance by those creditors who are impairedmust be received. This
Company,
explains the relatively recent phenomenon known as a "prepackaged significant holders of the third mortgage debt in the
Chapter 11," whereby the required (but not necessarily unanimous) Chapter 11 reorganizationof the Public Service of New
proportionof acceptingcreditorvotes is assembled for a plan prior to the
filing of the petition for relief (which initiates the bankruptcyprocess). In Hampshire,and Oppenheimer& Company's accumulation
most cases, the formalChapter11 reorganizationthatfollows the prepack of the unsecureddebt of Wheeling PittsburghSteel in its
agreementis a relatively simple procedure.The actual time spent in the contentious
bankruptcyprocesshas been as littleas one month,andit generallyaverages
reorganization.26
only a few months. The money spent in a prepackagedbankruptcyis also The second phenomenonis not really new but involves
typically less. See Altman (1993b), Betker (1995b), McConnell and the more organizedandaggressivepostureof well-informed
Servantes (1991), and Salerno and Hansen (1991) for discussions of
prepackagedplansandtheirrecentexperience.Betkeranalyzes49 cases and and well-financed representativesof a groupof creditorsin
concludes that while direct costs of prepacksare comparableto those of
traditionalChapter1is, gains come from the bindingof holdoutsand from
favorabletax treatmenton tax loss carryforwards. 26Thesecases are discussed in detailby Rosenberg(1992).

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74 FINANCIAL / SUMMER1995
MANAGEMENT

the Chapter 11 or pre-Chapter 11 negotiations. Skillful The shorterthe maturitystructureof debt,the morelikely
investmentbankers,with sufficient voting power, or even it is the firm will have an underinvestmentproblem. The
"nuisance-power," have gained far better terms in longerthe maturitystructureof the debt, the morelikely it is
reorganization than atomistic creditors might have the firm will have an overinvestmentproblem. A higher
achieved. (lower) ratio of short-termdebt to total debt can be used to
create an offsetting underinvestment (overinvestment)
VIII. Summary tendency.
In this paper, we have presented a synthesis of the Extendingthe maturityof existing debt and creatingnew
literature on financial distress. Within a two-state debt seniorto existing debtincreasesinvestmentincentives.
framework,we have developed a system of equationsthat However, it also increases the risks to the old debtholders.
generalizes more complex models. We explored the Similarly, exchange offers provide opportunities for
effects of financial distress on investment efficiency and managers acting on behalf of shareholders to behave
restructuringstrategyunderalternativeassumptions. strategicallytowardcreditors.
In the base case formulation, Myers' (1977) Our findings help evaluate key elements of the
underinvestmentmodel is shown to be a special case under BankruptcyReformAct of 1978.
certainty. The intuition of his result is that if the present
1) The automaticstay has the effect of extending
value of the firm's assets is less than the debt claims,
debt maturity,therebyincreasingthe firm's
the deficiency representsa tax that must be paid by the
shareholders before they can receive any returns from ability to obtainnew financingto makethe
investmentsrequiredfor its recovery.
additionalinvestments.This gives riseto anunderinvestment
problem. 2) The new voting rules requireonly a majority
Underuncertainty,theequityholdersgenerallyreceive an in numberof a class of creditors(and at least
undervalued option. Shareholders have incentives to two-thirdsin principalamount)to approvea
overinvestsince in some states the favorableoutcomes may reorganizationplan, therebyfacilitating
re-establishsome value for them. Overinvestmentis more negotiationsand approvalof a plan for
likely to occur when big differencesbetweenXb and Xg are reorganization.
expected. In contrast, when expected returns in the 3) Debtor-in-possession(DIP) financingchanges
alternativestatesarerelativelyequal,the value of the option the seniorityof claims, therebystimulatingnew
to pay off the debt and retain control over the firm is investment.
diminished. 4) The law providesfor absolutepriorityrules but
Underinvestmentmay occureven in the uncertaintycase. has permittedfrequentsmall departures,which
For cash flow levels at which debtholdersare paid off, but facilitatesobtainingagreementsto achieve plan
very little remains for the shareholders, the returns to approval.In general,departuresfrom absolute
shareholdersmay be negative. But NPV may be positive priorityincreasethe riskinessof debt. However,
since no debt payoff is required. So the influence of they may increasethe prospectivereturnsby
debt as a "tax" that has to be paid can also result in an reducingthe time requiredto obtainapprovalof
underinvestmentproblemin the more generalframework. a proposedreorganizationplan. U

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