Abstract This study documents the extent of the different forms of restructuring undertaken by financially distressed firms before a Chapter 11 filing. The study focuses on the following question: Does financial distress cause agency problems? , which is based on the analysis of financial statement ratios. Further analysis shows that the success or failure of financial restructuring before bankruptcy is a function of the assets. Due to time limitations, and considering the complexity of the ZETA'O model, this study is based in the Altman (1988) considerations. The relationship between financial distress and the stockholder-bondholder conflict Introduction Financing policy by firms requires managers to identify ways of funding new investment. The managers may exercise three main choices: use retained earnings, borrow through debt instruments, or issue new shares.

Thus, financing policy, capital structure and firm ownership are all strongly linked in explaining how economic agents form and modify their asset-acquisition behavior through firms and capital markets, and thereby influence their incomes and returns to asset holdings, whether in the form of direct remuneration, capital gains or dividends (Prasad, Green and Murinde, 2001). A particular firm wishes to finance projects in excess of the firm's internal resources. The firm has two options: to issue equity or debt. If the firm issues equity, the shareholder's fractional interest within the firm decreases. This increases the incentives for a shareholder to undertake excessive perk consumption since the costs to the owner of such activities have been lowered as a result of a reduction in his fractional interest.

Such costs include; i) the monitoring expenses of the principal (the equity holders); ii) the bonding expenses of the agent (the manager); and iii) the money value of the reduction in welfare experienced by the principal due to the divergence between the agent's decisions and those that maximize the welfare or the principal. In the presence of efficient markets, which incorporate expectations, external investors anticipate such actions by the shareholder of the firm (James, 1999). Accordingly, the price of new equity is discounted to take into account the monitoring costs of external shareholders. Under these circumstances, the shareholder would prefer to finance new projects using debt rather than equity.

Issuing debt to finance investment also incurs agency costs. These arise as a result of the conflict of interest between external lenders and the shareholder. The issue of debt increases the shareholder's incentive to invest in high-risk projects, which, if successful, offers high returns, which accrue exclusively to the shareholder but at the same time, increase the likelihood of failure. If the projects fail, the shareholder exposure is limited to the value of his equity holdings. Bondholders, on the other hand, do not share the profits of success, but will share in the costs of a bankruptcy: they are incurring extra risk without additional expected returns. As the amount of debt increases, bondholders will demand a higher premium to compensate them for the increased probability of failure.

Thus, the agency costs of debt include the opportunity costs caused by the impact of debt on the investment decisions of the firm; the monitoring and the bond expenditures by both the bondholders and the shareholder; and the costs associated with bankruptcy and reorganization (Hunsaker, 1999). In this study, the relationship between the financial distress and shareholder-bondholder conflict are analyzed, by considering the assets restructuring as a way to reduce the financial distress. Literature Review Agency costs associated with equity are at a maximum when the shareholder share of equity is zero, and stockholder wholly owns the firm. These costs fall to zero as the shareholder equity share rises to 100%. Similarly, the agency costs of debt are at a maximum when all external funds are obtained from debt.

As the level of debt falls, agency costs are reduced: first, because the amount of wealth that can be reallocated away from bondholders falls; and second, since the fraction of equity held by the shareholder is being reduced, the shareholder share of any reallocation also falls. When a firm is close to bankruptcy, shareholders have no incentive to inject new capital into value-increasing projects since the returns of such a venture will accrue mainly to bondholders. The larger the debt level of the firm, the less the incentive to invest in value-increasing projects. The conflict between shareholders and managers takes several distinct forms. The first, (Jensen and Meckling, 1976) is that managers prefer to have greater perquisite levels and lower effort levels, provided that they do not have to pay for these through lower wages or by a lower market value of their personal equity holdings. A second arises because managers may prefer short-term projects, which produce early results and enhance their reputation quickly, rather than more profitable long-term projects (Masulis, 1988).

Third, managers may prefer less risky investments and lower leverage to lessen the probability of bankruptcy (Hunsaker, 1999). Fourth, managers will wish to minimize the likelihood of employment termination. As this increases with changes in corporate control, management may resist takeovers, irrespective of their effect on shareholder value (Garvey and Hanka, 1999). Managers and shareholders may also disagree over a firm's operating decisions: Harris and Raviv (1990) observe the managers will typically wish to continue operating the firm even if liquidation is preferred by shareholders, managers may also prefer to invest all available funds even if shareholders want to be paid dividends (Stull, 1990).

Various underlying factors have been identified within the literature on the conflict of interest between shareholders and bondholders (Smith and Warner, 1979). i) Dividend payments: Bonds are priced according to the level of dividends paid by the firm. In the limit, a firm could sell all its assets and pay a liquidating dividend to its shareholders with the bondholders being left with valueless claims. ii) Claim dilution: Bonds are normally priced assuming that the firm will not carry any more leverage.

If the firm does issue additional debt, then existing debt will fall in value if the newly issued debt has higher priority. Even if it does not, existing debt will fall in value if the risk of bankruptcy is perceived to have increased. iii) Asset substitution: Bonds are priced in relation to the risk of the projects, which is being financed. Thus, lenders' claims are reduced if the firm substitutes projects that increase the firm's value. This transfers wealth from bondholders to shareholders. iv) Under-investment and mis-investment: A firm in financial difficulties has an incentive to reject low-risk, low (positive) net present value projects whose benefits accrue mainly to bondholders, in favor of high-risk, high net present value projects, thus creating under-investment or misallocation of investment.

To minimize these conflicts, firms with high growth opportunities should have higher leverage and use a greater amount of long-term debt than firms in more mature industries. A general view of financial distress is that it results from a mismatch between the currently available liquid assets of a firm and its current obligations under its "hard" financial contracts. The costs of financial distress will have important implications for the liquidity and leverage policies of a firm. In particular, when the costs of financial distress are high, the firm may maintain a larger fraction of its assets as liquid assets and / or be cautious in taking on debt (hard contracts). Methodology The financing contracts of a firm can be loosely categorized into hard and soft contracts. An example of a hard contract is a coupon debt contract, which specifies periodic payments by the firm to the bondholders.

If these payments are not made on time, the firm is considered to be in violation of the contract and the claim holders can seek specified and unspecified legal recourses to enforce the contract. Common stock and preferred stock are examples of soft contracts. A firm is in financial distress at a given point in time when the liquid assets of the firm are not sufficient to meet the current liquidity requirements of its hard contracts. Since financial distress results from a mismatch between the currently available liquid assets and the current obligations of its "hard" financial contracts, mechanisms for coping with financial distress involve correcting the mismatch by either increasing the liquidity of the assets (through asset sales) or decreasing the "hardness" of the debt contracts (through debt renegotiation). As financial distress can be resolved through asset restructuring (asset sales or other liquidations) and / or financial restructuring (private or formal debt re negotiations), the costs of these different mechanisms of resolving distress will represent financial distress costs. Financial distress will be relatively more costly for firms whose assets are more intangible or firm specific.

Replacement costs approximate what the firm's assets could be sold, and are positively correlated with the liquidation value of the asset. Firms with a higher market value / replacement costs ratio will have higher costs of asset liquidations. For several reasons, assets are more likely to be sold when debt is restructured in Chapter 11 rather than privately. First, automatic stay gives the debtor more power over the disposition of the firm's assets, by enjoining creditors from exercising their non-bankruptcy right to sue the firm and seize collateral.

Second, since the debtor can undermine the value of lenders' collateral and grant new lenders super priority standing, fully secured lenders will in general prefer liquidation over reorganization. This may create additional pressure for asset sales in bankruptcy. Finally, purchasing assets from a financially distressed firm is less risky in Chapter 11, because asset sales are executed by a court order and are thus free from legal challenge. Therefore the hypotesys designed for the evaluation of this consideration are based on the assets of the company, the hypotesys are: H 0: Financial distress is resolved through assets restructuring HA: Financial distress is not resolved through assets restructuring And the variables to consider in this analysis are: Earnings Before Income Tax (EBIT), Net Working Capital (NWC), Sales (S), Market Value of Equity (MVE), Acummulated Retained Earnings (ARE), Total Assets (TA) and the Book Value of Debt (BVD). Statistical Model After careful consideration of the nature of the problem and of the purpose of this analysis, the discriminant analysis (MDA) is chosen as the appropriate statistical technique. In recent years, this technique has become increasingly popular in the practical business world as well as in academia.

Altman (1981) discusses discriminant analysis in-depth and reviews several financial application areas. MDA is a statistical technique used to classify an observation into one of several a priori groupings dependent upon the observation's individual characteristics. It is used primarily to classify and / or make predictions in problems where the dependent variable appears in qualitative form, for example, male or female, bankrupt or non-bankrupt. Therefore, the first step is to establish explicit group classifications. The number of original groups can be two or more. Some analysts refer to discriminant analysis as "multiple" only when the number of groups exceeds two.

The multiple concepts will refer to the multivariate nature of the analysis. After the groups are established, data are collected for the objects in the groups; MDA in its most simple form attempts to derive a linear combination of these characteristics which "best" discriminates between the groups. If a particular object, for instance, a corporation, has characteristics (financial ratios), which can be quantified for all of the companies in the analysis, the MDA determines a set of discriminant coefficients. When these coefficients are applied to the actual ratios, a basis for classification into one of the mutually exclusive groupings exists. The MDA technique has the advantage of considering an entire profile of characteristics common to the relevant firms, as well as the interaction of these properties. Another advantage of MDA is the reduction of the analyst's space dimensionally, that is, from the number of different independent variables to G-1 dimension (s), where G equals the number of original a priori groups.

This analysis is concerned with two groups, consisting of bankrupt and non-bankrupt firms. Therefore, the analysis is transformed into its simplest form: one dimension. The discriminant function, of the form: Z = V 1 X 1+V 2 X 2+... +Vn Xn, transforms the individual variable values to a single discriminant score, or z value, which is then used to classify the object where: V 1, V 2, ... Vn = discriminant coefficients, and X 1, X 2, ... Xn = independent variables.

The MDA computes the discriminant coefficient; V 1 while the independent variables X 1 are the actual values. When utilizing a comprehensive list of financial ratios in assessing a firm's bankruptcy potential, there is a reason to believe that some of the measurements will have a high degree of correlation or co linearity with each other. While this aspect is not serious in discriminant analysis, it usually motivates careful selection of the predictive variables (ratios). It also has the advantage of potentially yielding a model with a relatively small number of selected measurements, which convey a great deal of information. This information might very well indicate differences among groups, but whether or not these differences are significant and meaningful is a more important aspect of the analysis. Perhaps the primary advantage of MDA in dealing with classification problems is the potential of analyzing the entire variable profile of the object simultaneously rather than sequentially examining its individual characteristics.

Just as linear and integer programming have improved upon traditional techniques in capital budgeting, the MDA approach to traditional ratio analysis has the potential to reformulate the problem correctly. Specifically, combinations of ratios can be analyzed together in order to remove possible ambiguities and misclassification's observed in earlier traditional ratio studies. As seen, the Z-score model is a linear analysis in that at least five measures are objectively weighted and summed up to arrive at an overall score that then becomes the basis for classification of firms into one of the a priori groupings (distressed and non distressed). A frequent argument is that financial ratios, by their very nature, have the effect of deflating statistics by size, and that therefore a good deal of the size effect is eliminated. The Z-Score model (ZETA'O), discussed below, appears to be sufficiently robust to accommodate large firms. The ZETA'O model did include larger sized distressed firms and is unquestionably relevant to both small and large firms.

The variables are classified into five standard ratio categories, including liquidity, profitability, leverage, solvency, and activity. Five variables are selected as doing the best overall job together in the prediction of corporate bankruptcy. The final discriminant function is as follows: Z = 3. 3 X 1 + 1. 2 X 2 + 1.

0 X 3 + 0. 6 X 4 + 1. 4 X 5 Where: X 1 = Earnings Before Income Tax / Total Assets, X 2 = Net working Capital / Total Assets, X 3 = Sales / Total Assets, X 4 = Market Value of Equity / Book Value of Debt, X 5 = Accumulated Retained Earnings / Total Assets Z = Overall Index X 1, Earnings Before Interest and Taxes / Total Assets/ (EBIT/TA), this ratio is a measure of the true productivity of the firm's assets, independent of any tax or leverage factors. X 2, Net Working Capital / Total Assets (NWC/TA), is a measure of the net liquid assets of the firm relative to the total capitalization. X 3, Sales / Total Assets (S/TA), is a measure of management's capacity in dealing with competitive conditions. X 4, Market Value of Equity / Book Value of Debt (MVE/BVD), the measure shows how much the firm's assets can decline in value (measured by market value of equity plus debt) before the liabilities exceed the assets and the firm becomes insolvent.

X 5, Accumulated Retained Earnings / Total Assets (ARE/TA), retained earnings is the account, which reports the total amount of reinvested earnings and / or losses of a firm over its entire life. Considering the data evaluated by Altman, the following values of Z were obtained to make the final observations about the effectiveness of using the assets in restructuring the debt of the company: Z < 1. 23 predicts bankruptcy 1. 23 > Z < 2. 90 indicates caution in financial status Z > 2. 90 indicates effective restructuring Due to time limitations, and considering the complexity of the ZETA'O model, this study is based in the Altman (1988) considerations.

To rebuild this study, future investigators must base the analysis in data found at F&S Index of corporate Change, which list companies that filled a Chapter 11 Bankruptcy petition, the Wall Street Journal Index, COMPU STAT and Estan dar & Poor Register of Corporations. Conclusion This study documents the extent of the different forms of restructuring undertaken by financially distressed firms before a Chapter 11 filing. We find that asset plays significant roles before bankruptcy. Altman (2000), analysis shows that the success or failure of financial restructuring before bankruptcy is a function. The high failure rate suggests that the holdout problem among creditor groups is severe.

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