Please research and then discuss the aspects of the bankruptcy process. Also, discuss capital structure and how a company’s structure impacts its progress through the bankruptcy process.
A company might need to file bankruptcy because of economic reason or financial reasons. Some businesses owe way too much than they can ever pay back, and at times interests payment on debts make it impossible to return to profit, then bankruptcy might be a viable option to return to profit and grow shareholder wealth. And another scenario can be, a company or service that is not relevant anymore, such as Toys R US, the industry is disrupted by online stores and the industry could not keep up, so they are going out of business.
A financially stressed company can consider filing for Chapter 7 or Chapter 11 bankruptcy in US. These 2 types are very different than each other and the creditors or equity holders are also affected differently.
Chapter 7 – in this case company goes out of business and they liquidate all their assets. The money generated from the liquidation is used to pay of the debts(Investopedia, n.d.). But not all debts are treated equally. Senior debt or secured debt get first priority to be paid off, so these types of debts are most secured but they usually come with low interest rates. After secured debts are paid off the money goes to pay off junior debt or unsecured debts and equity stock holders come last. The unsecured bond / debt holder own more risk than senior and secured debt / bond holders, so they earn more interest. After paying off all debts/bonds if anything remains leftover then that amount goes towards paying equity owner.
Chapter 11 – Companies apply for chapter 11 to restructure their debt / equity. And in this case Companies do not liquidate their assets. Because the company does not go out of business, so they do not sell their core assets. But to remain financially solvent the company goes through debt restructuring (Investopedia, n.d.).
Due to the complexity and expenses this type is often the last option. In Chapter 11 all debtholders and equity holders are represented by members in a committee, formed with a purpose to reduce debt and make the company profitable, while protecting the debt and equity owners’ interest as much as possible. But under Chapter 11, stock holders may not get any money and bond holders might get equity stake instead in new restructured company. And often all the stakeholders end up taking haircuts on their holdings and the new entity might require capital infusion.
Capital Structure is how a company finances its operations, such as purchasing assets or running day to day business. And a company can finance its activities with bonds, long term notes or selling equity / stocks in capital markets (Investopedia, n.d.). In current low interest rate environment most companies find it cheaper to finance with debt.
Companies prefer debt over selling equity, especially when growth is accelerating. Paying interest helps save taxes too. Selling equity is another option where stock holders participates in company’s upside and downside and this is most risky form of investment for. If company does well, equity holders get a part of profit, but there is no promise of interest payment like bonds.
When a company files of Chapter 7 bankruptcy and liquidates all the assets, the company stops all operations and goes completely out of business (SEC, 2009).AS we have seen before in this case the bondholders have higher chance of recovering their investments than the stockholders. This is comparatively simple, although it is never good for investors, but equity stock holders stand the chance to lose most. During bankruptcy bondholders do not receive any interest payment or stockholders do not receive any dividend payments. In case of Chapter 11, the equity stock holders might get shares in the new entity but one thing is for certain, they take a major hit on their initial investment.
Retrieved on 04/14/2018. Retrieved from https://www.sec.gov/reportspubs/investor-publications/investorpubsbankrupthtm.html
Retrieved on 4/14/2018. Retrieved from https://www.investopedia.com/terms/c/capitalstructure.asp
Retrieved on 4/14/2018. Retrieved from https://www.investopedia.com/articles/01/120501.asp