The Reluctance to Liquidate Problem

One of the most difficult decisions a firm must make is whether to remain in business. It must decide whether to continue to operate or to dismantle the business and sell its property and equipment for its liquidation value. Like the investment decision, the liquidation decision is affected by how much debt the firm has outstanding. In addition, the decision to liquidate can be affected by the firm's bankruptcy status.

Liquidation Costs versus Bankruptcy Costs. Liquidation costs are the difference between the firm's going concern value, the present value of the future cash flows that the firm's assets would generate if it were to continue operating, and its liquidation value, which is what the firm could collect by liquidating its assets and selling them. Because bankruptcy and liquidation often occur together, liquidation costs are sometimes considered a direct cost of bankruptcy. This makes them an important determinant of a firm's capital structure. However, as we pointed out at the beginning of this chapter, bankruptcy does not necessarily imply liquidation. Indeed, in many Chapter 11 bankruptcies, firms are reorganized and continue operating.

Generally, it is in the interests of both debt holders and equity holders to reorganize and to continue operating a bankrupt firm if its going concern value exceeds its liquidation value. As a result, firms that liquidate in bankruptcy tend to do so because the net proceeds from liquidation exceed the present value of the future cash flows that the firm would generate if it were to continue operating. Given that bankruptcy is likely to lead firms to liquidate when it is optimal to do so, liquidation costs should not be viewed as a relevant bankruptcy cost in determining the firm's optimal capital structure.16

How Capital Structure Affects Liquidation Policy. Although bankruptcy need not cause a firm to liquidate when it is worth more as a going concern, capital structure can still affect liquidation policy. Managers of financially sound firms, as representatives of their equity holders, have an incentive to continue operating their firm even when the liquidation values of the firm exceed its going concern value.17 To understand this point, remember that equity holders, as the firm's most junior claimant, receive proceeds from the liquidation only after all other claimants have been satisfied. Therefore, if the face value of a firm's debt exceeds the firm's liquidation value, equity holders are likely to receive nothing in a liquidation. In addition, compared to the payoff from continuing to operate, liquidation provides a relatively safe payoff. Therefore, liquidation will be less attractive to equity holders than the riskier alternative of continuing to operate. This is analogous to the decision not to exercise an out-of-the-money option, again viewing equity as a call option on the value of the firm—the option is worth nothing if exercised, but it still might pay off in the future.

Managers, of course, have a direct interest in keeping the firm operating, even when the firm's liquidation value exceeds its operating value, because they are likely to lose their jobs if the firm liquidates. Hence, they have a strong incentive to continue operating as long as they control the firm. In the event of bankruptcy, managers and equity holders lose much of their control to representatives of debt holders who have an interest in liquidating the firm if doing so enhances the firm's value. As a result, whether a firm liquidates depends on who has the power to make that decision.

The Financial Distress of Eastern Airlines. Consider the problem faced by Eastern Airlines when it was on the verge of bankruptcy during a recession in 1989. Suppose it had a $500 million debt obligation and that its going concern value would be worth $600 million if the economy recovered (a 50 percent probability), but the company would be forced to liquidate and receive proceeds of only $200 million if the recession continued. Alternatively, it could liquidate immediately and receive $480 million.

16See Haugen and Senbet (1978) for further elaboration of this point.

17See Titman (1984) and Gertner and Sharfstein (1991) for further discussion of this point.

Chapter 16 Bankruptcy Costs and Debt Holder-Equity Holder Conflicts 577

Eastern's equity holders would clearly prefer to keep the airline going in this situation since there would be nothing left for them in a liquidation once debt holders were paid off. However, the firm can keep going until the economy turns around, equity holders would realize a value of $100 million ($600 million - $500 million). The debt holders, however, prefer to have the airline liquidate its assets immediately! Debt holders realize that there is a 50 percent chance that they will be paid in full if the economy recovers. However, there also is a 50 percent chance that most of the liquidation value will be dissipated if the debt holders wait to liquidate, leaving them with only $200 million. The case of Eastern Airlines illustrates the following result:

Result 16.10 Since debt holders have priority in the event of liquidation, they have a stronger interest in liquidating the assets of a distressed firm than the firm's equity holders, who profit from the possible upside benefits that may be realized if the firm continues to operate. As a result, a firm's financial structure partially determines the conditions under which it liquidates.

Bankruptcy and Liquidation Decisions of Firms with More Than One Class of Debt. When a firm has more than one class of debt (for example, junior and senior debt) the determinants of its bankruptcy and liquidation decisions become considerably more complicated. For the purpose of this discussion, assume that a firm will go bankrupt if the following conditions hold:

• It has insufficient cash flow to meet its debt obligations.

• It is unable to borrow a sufficient amount to meet its debt obligations.

One might think that the preceding conditions imply that a firm would be bankrupt if it were not generating sufficient cash flow to meet its current debt obligations and if it is not expecting improvements in the future. As shown below, however, this is not necessarily true, and such a firm might continue to operate as a going concern even when its liquidation value greatly exceeds its going concern value.

To understand how a firm can remain in business under these conditions, consider the differing incentives of the firm's equity holders and debt holders in the event of a financial crisis. Equity holders have an incentive to delay bankruptcy and an even greater incentive to delay liquidation. The value of the equity holders' claims, with their option-like characteristics, increases as its time to maturity lengthens. For this reason, management, when acting in the equity holders' interests, will want to avoid defaulting on the company's debt obligations. Defaulting would make all of the firm's current obligations come due immediately, which in effect would eliminate the option value of the equity claims.

For similar reasons, junior creditors also may be reluctant to force a firm into bankruptcy since their claims also have option-like features.18 In many cases, these junior creditors may find it in their interest to lend additional money to a firm in financial distress to keep it from going bankrupt. Thus, a lender may be willing to make a new loan—which by itself is not a good investment—if doing so increases the value of its past loans to the firm.

Consider, for example, the case of Emruss Industries which has no cash flow in the current period, but will have cash flows of $1.5 million next year if the economy is favorable and $0.5 million if the economy is unfavorable. Assuming risk neutrality, a zero discount rate, and equal probabilities of the two events, the going concern value of the firm is $1.0 million. Also assume that if the firm were liquidated immediately, it would generate

18See Bulow and Shoven (1978) for further discussion.

Exhibit 16.6 Emruss's Debt Obligations

Debt Obligations

Immediate

Next Year

Senior debt holders

$150,000

$1,000,000

Venture capitalist

0

200,000

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