Corporate Finance

829

When news breaks about a firm’s bank accounts, it’s usu- ally because the company is running low on cash. However, that wasn’t the case for many companies in early 2015. For example, two of the largest cash balances were held by tech giants Cisco and Microsoft, which held about $52.1 billion and $90.2 billion in cash, respectively. Similarly strik- ing was Google’s cash balance of about $61.2 billion, which

amounted to about $90 per share! Other companies also had large amounts of cash. General Electric (GE) had a cash balance of about $137.4 billion. But no company came close to investment bank Goldman Sachs, with a cash hoard of $224 billion. Why would firms such as these hold such large quantities of cash? We examine cash management in this chapter to find out.

Cash Management

27

This chapter is about how firms manage cash. The basic objective of cash management is to keep the investment in cash as low as possible while still keeping the firm operating effi- ciently and effectively. This goal usually reduces to the dictum, “Collect early and pay late.” Accordingly, we discuss ways of accelerating collections and managing disbursements.

In addition, firms must invest temporarily idle cash in short-term marketable securi- ties. As we discuss in various places, these securities can be bought and sold in the finan- cial markets. As a group they have very little default risk, and most are highly marketable. There are different types of these so-called money market securities, and we discuss a few of the most important ones.

Reasons for Holding Cash John Maynard Keynes, in his classic work The General Theory of Employment, Interest, and Money, identified three motives for liquidity: The speculative motive, the precaution- ary motive, and the transaction motive. We discuss these next.

THE SPECULATIVE AND PRECAUTIONARY MOTIVES The speculative motive is the need to hold cash in order to be able to take advantage of, for example, bargain purchases that might arise, attractive interest rates, and (in the case of international firms) favorable exchange rate fluctuations.

For most firms, reserve borrowing ability and marketable securities can be used to satisfy speculative motives. Thus, there might be a speculative motive for maintaining liquidity, but not necessarily for holding cash per se. Think of it this way: If you have a credit card with a very large credit limit, then you can probably take advantage of any unusual bargains that come along without carrying any cash.

27.1

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830 ■■■ PART VII Short-Term Finance

This is also true, to a lesser extent, for precautionary motives. The precautionary motive is the need for a safety supply to act as a financial reserve. Once again, there prob- ably is a precautionary motive for maintaining liquidity. However, given that the value of money market instruments is relatively certain and that instruments such as T-bills are extremely liquid, there is no real need to hold substantial amounts of cash for precaution- ary purposes.

THE TRANSACTION MOTIVE Cash is needed to satisfy the transaction motive: the need to have cash on hand to pay bills. Transaction-related needs come from the normal disbursement and collection activi- ties of the firm. The disbursement of cash includes the payment of wages and salaries, trade debts, taxes, and dividends.

Cash is collected from product sales, the selling of assets, and new financing. The cash inflows (collections) and outflows (disbursements) are not perfectly synchronized, and some level of cash holdings is necessary to serve as a buffer.

As electronic funds transfers and other high-speed, “paperless” payment mechanisms continue to develop, even the transaction demand for cash may all but disappear. Even if it does, however, there will still be a demand for liquidity and a need to manage it efficiently.

COMPENSATING BALANCES Compensating balances are another reason to hold cash. As we discussed in the previous chapter, cash balances are kept at commercial banks to compensate for banking services the firm receives. A minimum compensating balance requirement may impose a lower limit on the level of cash a firm holds.

COSTS OF HOLDING CASH When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The opportunity cost of excess cash (held in currency or bank deposits) is the inter- est income that could be earned by the next best use, such as investment in marketable securities.

Given the opportunity cost of holding cash, why would a firm hold cash in excess of its compensating balance requirements? The answer is that a cash balance must be main- tained to provide the liquidity necessary for transaction needs—paying bills. If the firm maintains too small a cash balance, it may run out of cash. If this happens, the firm may have to raise cash on a short-term basis. This could involve, for example, selling market- able securities or borrowing.

Activities such as selling marketable securities and borrowing involve various costs. As we’ve discussed, holding cash has an opportunity cost. To determine the appropriate cash balance, the firm must weigh the benefits of holding cash against these costs. We discuss this subject in more detail in the sections that follow.

CASH MANAGEMENT VERSUS LIQUIDITY MANAGEMENT Before we move on, we should note that it is important to distinguish between true cash management and a more general subject, liquidity management. The distinction is a source of confusion because the word cash is used in practice in two different ways. First of all, it has its literal meaning, actual cash on hand. However, financial managers frequently use the word to describe a firm’s holdings of cash along with its marketable securities, and marketable securities are sometimes called cash equivalents, or near-cash. In our

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CHAPTER 27 Cash Management ■■■ 831

discussion of various firms’ cash positions at the beginning of the chapter, for example, what was actually being described was their total cash and cash equivalents.

The distinction between liquidity management and cash management is straightfor- ward. Liquidity management concerns the optimal quantity of liquid assets a firm should have on hand, and it is one particular aspect of the current asset management policies we discussed in our previous chapter. Cash management is much more closely related to optimizing mechanisms for collecting and disbursing cash, and it is this subject that we primarily focus on in this chapter.

In general, the firm needs to balance the benefits of holding cash to meet transactions and avoid insolvency against the opportunity costs of lower returns. A sensible cash man- agement policy is to have enough cash on hand to meet the obligations that may arise in the ordinary course of business and to invest some excess cash in marketable securities for precautionary purposes. All other excess cash should be invested in the business or paid out to investors.1

Understanding Float As you no doubt know, the amount of money you have according to your checkbook can be very different from the amount of money that your bank thinks you have. The reason is that some of the checks you have written haven’t yet been presented to the bank for payment. The same thing is true for a business. The cash balance that a firm shows on its books is called the firm’s book, or ledger, balance. The balance shown in its bank account as available to spend is called its available, or collected, balance. The difference between the available balance and the ledger balance, called the float, represents the net effect of checks in the process of clearing (moving through the banking system).

DISBURSEMENT FLOAT Checks written by a firm generate disbursement float, causing a decrease in the firm’s book balance but no change in its available balance. For example, suppose General Mechanics, Inc. (GMI), currently has $100,000 on deposit with its bank. On June 8, it buys some raw materials and pays with a check for $100,000. The company’s book balance is immedi- ately reduced by $100,000 as a result.

GMI’s bank, however, will not find out about this check until it is presented to GMI’s bank for payment on, say, June 14. Until the check is presented, the firm’s available bal- ance is greater than its book balance by $100,000. In other words, before June 8, GMI has a zero float:

Float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 100,000 5 $0

GMI’s position from June 8 to June 14 is:

Disbursement float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 0 5 $100,000

27.2

1There is some evidence that corporate governance has some role in the cash holdings of U.S. firms. Jarrad Harford, Sattar A. Mansi, and William F. Maxwell, in “Corporate Governance and Firm Cash Holdings in the U.S.,” Journal of Financial Economics 87, no. 3 (2008), pp. 535–55, find that firms with weaker corporate governance systems have smaller cash reserves. The combination of excess cash and weak governance leads to more capital spending and more acquisitions.

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832 ■■■ PART VII Short-Term Finance

While the check is clearing, GMI has a balance with the bank of $100,000. It can obtain the benefit of this cash during this period. For example, the available balance could be temporarily invested in marketable securities and thus earn some interest. We will return to this subject a little later.

COLLECTION FLOAT AND NET FLOAT Checks received by the firm create collection float. Collection float increases book balances but does not immediately change available balances. For example, suppose GMI receives a check from a customer for $100,000 on October 8. Assume, as before, that the company has $100,000 deposited at its bank and a zero float. It deposits the check and increases its book balance by $100,000 to $200,000. However, the additional cash is not available to GMI until its bank has presented the check to the customer’s bank and received $100,000. This will occur on, say, October 14. In the meantime, the cash position at GMI will reflect a collection float of $100,000. We can summarize these events. Before October 8, GMI’s position is:

Float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 100,000 5 $0

GMI’s position from October 8 to October 14 is:

Collection float 5 Firm’s available balance 2 Firm’s book balance 5 $100,000 2 200,000 5 2$100,000

In general, a firm’s payment (disbursement) activities generate disbursement float, and its collection activities generate collection float. The net effect—that is, the sum of the total collection and disbursement floats—is the net float. The net float at a point in time is simply the overall difference between the firm’s available balance and its book balance. If the net float is positive, then the firm’s disbursement float exceeds its collection float, and its available balance exceeds its book balance. If the available balance is less than the book balance, then the firm has a net collection float.

A firm should be concerned with its net float and available balance more than with its book balance. If a financial manager knows that a check written by the company will not clear for several days, that manager will be able to keep a lower cash balance at the bank than might be possible otherwise. This can generate a great deal of money.

For example, take the case of ExxonMobil. The average daily sales of ExxonMobil are about $1 billion. If ExxonMobil’s collections could be sped up by a single day, then ExxonMobil could free up $1 billion for investing. At a relatively modest .01  percent daily rate, the interest earned would be on the order of $100,000 per day.

EXAMPLE 27.1 Staying Afloat Suppose you have $5,000 on deposit. One day, you write a check for $1,000 to

pay for books, and you deposit $2,000. What are your disbursement, collection, and net floats? After you write the $1,000 check, you show a balance of $4,000 on your books, but the bank

shows $5,000 while the check is clearing. The difference is a disbursement float of $1,000. After you deposit the $2,000 check, you show a balance of $6,000. Your available balance

doesn’t rise until the check clears. This results in a collection float of −$2,000. Your net float is the sum of the collection and disbursement floats, or −$1,000.

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CHAPTER 27 Cash Management ■■■ 833

FLOAT MANAGEMENT Float management involves controlling the collection and disbursement of cash. The objective of cash collection is to speed up collections and reduce the lag between the time customers pay their bills and the time the cash becomes available. The objective of cash disbursement is to control payments and minimize the firm’s costs associated with making payments.

Total collection or disbursement times can be broken down into three parts: Mailing time, processing delay, and availability delay:

1. Mailing time is the part of the collection and disbursement processes during which checks are trapped in the postal system.

2. Processing delay is the time it takes the receiver of a check to process the payment and deposit it in a bank for collection.

3. Availability delay refers to the time required to clear a check through the banking system.

Speeding up collections involves reducing one or more of these components. Slowing up disbursements involves increasing one of them. We will describe some procedures for managing collection and disbursement times later. First, we need to discuss how float is measured.

Measuring Float The size of the float depends on both the dollars and the time delay involved. For example, suppose you mail a check for $500 to another state each month. It takes five days in the mail for the check to reach its destination (the mailing time) and one day for the recipient to get over to the bank (the processing delay). The recipi- ent’s bank holds out-of-state checks for three days (availability delay). The total delay is 5 1 1 1 3 5 9 days.

In this case, what is your average daily disbursement float? There are two equivalent ways of calculating the answer. First, you have a $500 float for nine days, so we say that the total float is 9 3 $500 5 $4,500. Assuming 30 days in the month, the average daily float is $4,500/30 5 $150.

Alternatively, your disbursement float is $500 for 9 days out of the month and zero the other 21 days (again, assuming 30 days in a month). Your average daily float is thus:

Average daily float 5 (9 3 $500 1 21 3 $0)/30 5 9/30 3 $500 1 21/30 3 $0 5 $4,500/30 5 $150

This means that, on an average day, your book balance is $150 less than your available balance, representing a $150 average disbursement float.

Overall, you show $6,000 on your books. The bank shows a $7,000 balance, but only $5,000 is available because your deposit has not been cleared. The discrepancy between your available balance and your book balance is the net float (−$1,000), and it is bad for you. If you write another check for $5,500, there may not be sufficient available funds to cover it, and it might bounce. This is why financial managers have to be more concerned with available balances than book balances.

For a real-world example of float management services, visit www.carreker .fiserv.com.

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Things are only a little more complicated when there are multiple disbursements or receipts. To illustrate, suppose Concepts, Inc., receives two items each month as follows:

Amount

Processing and availability delay

Total float

Item 1: $5,000,000 Item 2: $3,000,000   Total: $8,000,000

3 9 3 5

= $45,000,000 = $15,000,000 $60,000,000

The average daily float is equal to:

Average daily float 5 Total float _________ Total days (27.1) 5 $60 million __________ 30 5 $2 million

So, on an average day, there is $2 million that is uncollected and not available. Another way to see this is to calculate the average daily receipts and multiply by the

weighted average delay. Average daily receipts are:

Average daily receipts 5 Total receipts

____________ Total days 5 $8 million _________ 30 5 $266,666.67

Of the $8 million total receipts, $5 million, or 5⁄8 of the total, is delayed for nine days. The other 3⁄8 is delayed for five days. The weighted average delay is thus:

Weighted average delay 5 (5y8) 3 9 days 1 (3y8) 3 5 days 5 5.625 1 1.875 5 7.50 days

The average daily float is thus:

Average daily float 5 Average daily receipts 3 Weighted average delay (27.2)

5 $266,666.67 3 7.50 days 5 $2 million

Some Details In measuring float, there is an important difference to note between collection and disbursement float. We defined float as the difference between the firm’s available cash balance and its book balance. With a disbursement, the firm’s book balance goes down when the check is mailed, so the mailing time is an important component in disbursement float. However, with a collection, the firm’s book balance isn’t increased until the check is received, so mailing time is not a component of collection float.

This doesn’t mean that mailing time is not important. The point is that when collection float is calculated, mailing time should not be considered. As we will discuss, when total collection time is considered, the mailing time is a crucial component.

Also, when we talk about availability delay, how long it actually takes a check to clear isn’t really crucial. What matters is how long we must wait before the bank grants availability—that is, use of the funds. Banks actually use availability schedules to determine how long a check is held based on time of deposit and other factors. Beyond this, availability delay can be a matter of negotiation between the bank and a customer. In a similar vein, for outgoing checks, what matters is the date our account is debited, not when the recipient is granted availability.

Cost of the Float The basic cost of collection float to the firm is simply the oppor- tunity cost of not being able to use the cash. At a minimum, the firm could earn interest on the cash if it were available for investing.

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CHAPTER 27 Cash Management ■■■ 835

Suppose the Lambo Corporation has average daily receipts of $1,000 and a weighted average delay of three days. The average daily float is thus 3 3 $1,000 5 $3,000. This means that, on a typical day, there is $3,000 that is not earning interest. Suppose Lambo could eliminate the float entirely. What would be the benefit? If it costs $2,000 to eliminate the float, what is the NPV of doing so?

Figure 27.1 illustrates the situation for Lambo. Suppose Lambo starts with a zero float. On a given day, Day 1, Lambo receives and deposits a check for $1,000. The cash will become available three days later on Day 4. At the end of the day on Day 1, the book balance is $1,000 more than the available balance, so the float is $1,000. On Day 2, the firm receives and deposits another check. It will collect three days later on Day 5. At the end of Day 2, there are two uncollected checks, and the books show a $2,000 bal- ance. The bank, however, still shows a zero available balance; so the float is $2,000. The same sequence occurs on Day 3, and the float rises to a total of $3,000.

On Day 4, Lambo again receives and deposits a check for $1,000. However, it also collects $1,000 from the Day 1 check. The change in book balance and the change in avail- able balance are identical, 1$1,000; so the float stays at $3,000. The same thing happens every day after Day 4; the float therefore stays at $3,000 forever.2

Figure 27.2 illustrates what happens if the float is eliminated entirely on some Day t in the future. After the float is eliminated, daily receipts are still $1,000. The firm collects the same day because the float is eliminated, so daily collections are also still $1,000. As Figure 27.2 illustrates, the only change occurs the first day. On that day, as usual, Lambo collects $1,000 from the sale made three days before. Because the float is gone, it also collects on the sales made two days before, one day before, and that same day, for an addi- tional $3,000. Total collections on Day t are thus $4,000 instead of $1,000.

What we see is that Lambo generates an extra $3,000 on Day t by eliminating the float. On every subsequent day, Lambo receives $1,000 in cash just as it did before the

Figure 27.1 Buildup of the Float

Beginning float Checks received Checks cleared (cash available) Ending float

$ 0 1,000

2 0 $1,000

1 2 3 54

Day

$1,000 1,000

2 0 $2,000

$2,000 1,000

2 0 $3,000

$3,000 1,000

2 1,000 $3,000

$3,000 1,000

2 1,000 $3,000

. . .

. . .

. . .

. . .

. . .

Beginning float Checks received Checks cleared (cash available) Ending float

$3,000 1,000

2 4,000 $ 0

t t 1 1 t 1 2

Day

$ 0 1,000

2 1,000 $ 0

$ 0 1,000

2 1,000 $ 0

. . .

. . .

. . .

. . .

. . .

Figure 27.2 Effect of Eliminating

the Float

2This permanent float is sometimes called the steady-state float.

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836 ■■■ PART VII Short-Term Finance

float was eliminated. Thus, the only change in the firm’s cash flows from eliminating the float is this extra $3,000 that comes in immediately. No other cash flows are affected, so Lambo is $3,000 richer.

In other words, the PV of eliminating the float is simply equal to the total float. Lambo could pay this amount out as a dividend, invest it in interest-bearing assets, or do anything else with it. If it costs $2,000 to eliminate the float, then the NPV is $3,000 2 2,000 5 $1,000; so Lambo should do it.

EXAMPLE 27.2

EXAMPLE 27.3

Reducing the Float: Part I Instead of eliminating the float, suppose Lambo can reduce it to one day. What is the maximum Lambo should be willing to pay for this?

If Lambo can reduce the float from three days to one day, then the amount of the float will fall from $3,000 to $1,000. From our immediately preceding discussion, we see right away that the PV of doing this is equal to the $2,000 float reduction. Lambo should thus be willing to pay up to $2,000.

Reducing the Float: Part II Look back at Example 27.2. A large bank is willing to provide the float reduction service for $175 per year, payable at the end of each year. The relevant discount rate is 8 percent. Should Lambo hire the bank? What is the NPV of the investment? How do you interpret this discount rate? What is the most per year that Lambo should be willing to pay?

The PV to Lambo is still $2,000. The $175 would have to be paid out every year forever to maintain the float reduction; so the cost is perpetual, and its PV is $175/.08 5 $2,187.50. The NPV is $2,000 2 2,187.50 5 2$187.50; therefore, the service is not a good deal.

Ignoring the possibility of bounced checks, the discount rate here corresponds most closely to the cost of short-term borrowing. The reason is that Lambo could borrow $1,000 from the bank every time a check was deposited and pay it back three days later. The cost would be the interest that Lambo would have to pay.

The most Lambo would be willing to pay is whatever charge results in an NPV of zero. This zero NPV occurs when the $2,000 benefit exactly equals the PV of the costs—that is, when $2,000 5 C / .08, where C is the annual cost. Solving for C, we find that C 5 .08 3 $2,000 5 $160 per year.

Ethical and Legal Questions The cash manager must work with collected bank cash balances and not the firm’s book balance (which reflects checks that have been deposited but not collected). If this is not done, a cash manager could be drawing on uncol- lected cash as a source of funds for short-term investing. Most banks charge a penalty rate for the use of uncollected funds. However, banks may not have good enough accounting and control procedures to be fully aware of the use of uncollected funds. This raises some ethical and legal questions for the firm.

ELECTRONIC DATA INTERCHANGE AND CHECK 21: THE END OF FLOAT? Electronic data interchange (EDI) is a general term that refers to the growing practice  of direct, electronic information exchange between all types of businesses. One important use of EDI, often called financial EDI, or FEDI, is to electronically transfer financial information and funds between parties, thereby eliminating paper invoices, paper checks, mailing, and

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CHAPTER 27 Cash Management ■■■ 837

handling. For example, it is now possible to arrange to have your checking account directly debited each month to pay many types of bills, and corporations now routinely directly deposit paychecks into employee accounts. More generally, EDI allows a seller to send a bill electronically to a buyer, thereby avoiding the mail. The buyer can then authorize payment, which also occurs electronically. Its bank then transfers the funds to the seller’s account at a different bank. The net effect is that the length of time required to initiate and complete a business transaction is shortened considerably, and much of what we normally think of as float is sharply reduced or eliminated. As the use of FEDI increases (which it will), float management will evolve to focus much more on issues surrounding computerized informa- tion exchange and funds transfers.

One of the drawbacks of EDI (and FEDI) is that it is expensive and complex to set up. However, with the growth of the Internet, a new form of EDI has emerged: Internet e-commerce. For example, networking giant Cisco Systems books millions in orders each day on its website from resellers around the world. Firms are also linking to critical sup- pliers and customers via “extranets,” which are business networks that extend a company’s internal network. Because of security concerns and lack of standardization, don’t look for e-commerce and extranets to eliminate the need for EDI anytime soon. In fact, these are complementary systems that will most likely be used in tandem as the future unfolds.

On October 29, 2004, the Check Clearing for the 21st Century Act, also known as Check 21, took effect. Before Check 21, a bank receiving a check was required to send the physical check to the customer’s bank before payment could be made. Now a bank can transmit an electronic image of the check to the customer’s bank and receive payment immediately. Previously, an out-of-state check might take three days to clear. But with Check 21, the clearing time is typically one day; and often a check can clear the same day it is written. Thus, Check 21 promises to significantly reduce float.

Cash Collection and Concentration From our previous discussion, we know that collection delays work against the firm. All other things being the same, a firm will adopt procedures to speed up collections and thereby decrease collection times. In addition, even after cash is collected, firms need procedures to funnel, or concentrate, that cash where it can be best used. We discuss some common collection and concentration procedures next.

COMPONENTS OF COLLECTION TIME Based on our previous discussion, we can depict the basic parts of the cash collection pro- cess as follows. The total time in this process is made up of mailing time, check-processing delay, and the bank’s availability delay.

27.3

Customer mails

payment

Company receives payment

Mailing time

Processing delay

Availability delay

Collection time

Time

Company deposits payment

Cash available

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838 ■■■ PART VII Short-Term Finance

The amount of time that cash spends in each part of the cash collection process depends on where the firm’s customers and banks are located and how efficient the firm is in collecting cash.

CASH COLLECTION How a firm collects from its customers depends in large part on the nature of the business. The simplest case would be a business such as a restaurant chain. Most of its customers will pay with cash, check, or credit card at the point of sale (this is called over-the-counter collection), so there is no problem with mailing delay. Normally, the funds will be depos- ited in a local bank, and the firm will have some means (discussed later) of gaining access to the funds.

When some or all of the payments a company receives are checks that arrive through the mail, all three components of collection time become relevant. The firm may choose to have all the checks mailed to one location; more commonly, the firm might have a number of different mail collection points to reduce mailing times. Also, the firm may run its col- lection operation itself or might hire an outside firm that specializes in cash collection. We discuss these issues in more detail in the following pages.

Other approaches to cash collection exist. One that is becoming more common is the preauthorized payment arrangement. With this arrangement, the payment amounts and payment dates are fixed in advance. When the agreed-upon date arrives, the amount is automatically transferred from the customer’s bank account to the firm’s bank account, which sharply reduces or even eliminates collection delays. The same approach is used by firms that have online terminals, meaning that when a sale is rung up, the money is immediately transferred to the firm’s accounts.

LOCKBOXES When a firm receives its payments by mail, it must decide where the checks will be mailed and how the checks will be picked up and deposited. Careful selection of the number and locations of collection points can greatly reduce collection times. Many firms use special post office boxes called lockboxes to intercept payments and speed up cash collection.

Figure 27.3 illustrates a lockbox system. The collection process is started by cus- tomers mailing their checks to a post office box instead of sending them to the firm. The lockbox is maintained by a local bank. A large corporation may actually maintain more than 20 lockboxes around the country.

In the typical lockbox system, the local bank collects the lockbox checks several times a day. The bank deposits the checks directly to the firm’s account. Details of the operation are recorded (in some computer-usable form) and sent to the firm.

A lockbox system reduces mailing time because checks are received at a nearby post office instead of at corporate headquarters. Lockboxes also reduce processing time because the corporation doesn’t have to open the envelopes and deposit checks for collec- tion. All in all, a bank lockbox system should enable a firm to get its receipts processed, deposited, and cleared faster than if it were to receive checks at its headquarters and deliver them itself to the bank for deposit and clearing.

Some firms have turned to what are called “electronic lockboxes” as an alternative to traditional lockboxes. In one version of an electronic lockbox, customers use the telephone or the Internet to access their account—say, their credit card account at a bank—review their bill, and authorize payment without paper ever having changed hands on either end of the transaction. Clearly, an electronic lockbox system is far superior to traditional bill

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payment methods, at least from the biller’s perspective. Look for systems like this to con- tinue to grow in popularity.

CASH CONCENTRATION As we discussed earlier, a firm will typically have a number of cash collection points; as a result, cash collections may end up in many different banks and bank accounts. From here the firm needs procedures to move the cash into its main accounts. This is called cash concentration. By routinely pooling its cash, the firm greatly simplifies its cash manage- ment by reducing the number of accounts that must be tracked. Also, by having a larger pool of funds available, a firm may be able to negotiate or otherwise obtain a better rate on any short-term investments.

In setting up a concentration system, firms will typically use one or more concentra- tion banks. A concentration bank pools the funds obtained from local banks contained within some geographic region. Concentration systems are often used in conjunction with lockbox systems. Figure 27.4 illustrates how an integrated cash collection and cash con- centration system might look. As Figure 27.4 illustrates, a key part of the cash collection and concentration process is the transfer of funds to the concentration bank. There are sev- eral options available for accomplishing this transfer. The cheapest is a depository transfer

Figure 27.3 Overview of Lockbox

Processing

The flow starts when a corporate customer mails remittances to a post office box instead of to the corporation. Several times a day, the bank collects the lockbox receipts from the post office. The checks are then put into the company bank accounts.

Post office box 1

Post office box 2

Customer payments

Customer payments

Customer payments

Customer payments

Firm processes receivables

Local bank collects funds from

post office boxes

Bank begins check-clearing

process

Envelopes opened; separation of

checks and receipts

Deposit of checks into bank accounts

Details of receivables go to firm

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840 ■■■ PART VII Short-Term Finance

check (DTC), which is a preprinted check that usually needs no signature and is valid only for transferring funds between specific accounts within the same firm. The money becomes available one to two days later. Automated clearinghouse (ACH) transfers are basically electronic versions of paper checks. These may be more expensive, depending on the circumstances, but the funds are available the next day. The most expensive means of transfer are wire transfers, which provide same-day availability. Which approach a firm will choose depends on the number and size of payments. For example, a typical ACH transfer might be $200, whereas a typical wire transfer would be several million dollars. Firms with a large number of collection points and relatively small payments will choose the cheaper route, whereas firms that receive smaller numbers of relatively large payments may choose more expensive procedures.

ACCELERATING COLLECTIONS: AN EXAMPLE The decision of whether or not to use a bank cash management service incorporating lock- boxes and concentration banks depends on where a firm’s customers are located and the speed of the U.S. postal system. Suppose Atlantic Corporation, located in Philadelphia, is consider- ing a lockbox system. Its collection delay is currently eight days.

The Association for Financial Professionals has current info about cash management, www.afponline.org.

Figure 27.4 Lockboxes and Concentration

Banks in a Cash Management System

Funds are transferred to concentration bank

Cash manager analyzes bank balance and deposit information and makes cash allocation revision

Statements are sent by mail to firm for receivables processing

Customer payments

Customer payments

Maintenance of cash reserves

Disbursement activity

Short-term investment of cash

Maintenance of compensating

balance at creditor bank

Firm sales office

Concentration bank

Local bank deposits

Post office lockbox receipts

Customer payments

Customer payments

Firm cash manager

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CHAPTER 27 Cash Management ■■■ 841

Atlantic does business in the southwestern part of the country (New Mexico, Arizona, and California). The proposed lockbox system would be located in Los Angeles and oper- ated by Pacific Bank. Pacific Bank has analyzed Atlantic’s cash-gathering system and has concluded that it can decrease collection time by two days. Specifically, the bank has come up with the following information on the proposed lockbox system:

Reduction in mailing time 5 1.0 day Reduction in clearing time 5 .5 day Reduction in firm processing time 5 .5 day

Total 5 2.0 days

The following is also known:

Daily interest on Treasury bills 5 .025% Average number of daily payments to lockboxes 5 2,000 Average size of payment 5 $600

The cash flows for the current collection operation are shown in the following cash flow time chart:

0

Customer mails check

Mailing time

Processing delay

Availability delay

Check is

received

Deposit is

made

Cash is

available

Day 1 2 3 4 5 6 7 8

0

Customer mails check

Mailing time

Processing delay

Availability delay

Check is

received

Deposit is

made

Cash is

available

1 2 3 3.5 Day

4 5 6

The cash flows for the lockbox collection operation will be as follows:

Pacific Bank has agreed to operate this lockbox system for a fee of 25 cents per check processed. Should Atlantic give the go-ahead?

We first need to determine the benefit of the system. The average daily collections from the southwestern region are $1.2 million (52,000 3 $600). The collection time will be decreased by two days, so the lockbox system will increase the collected bank balance by $1.2 million 3 2 5 $2.4 million. In other words, the lockbox system releases $2.4 million to the firm by reducing processing, mailing, and clearing time by two days. From our earlier discussion, we know that this $2.4 million is the PV of the proposal.

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842 ■■■ PART VII Short-Term Finance

To calculate the NPV, we need to determine the PV of the costs. There are several different ways to proceed. First, at 2,000 checks per day and $.25 per check, the daily cost is $500. This cost will be incurred every day forever. At an interest rate of .025 percent per day, the PV is therefore $500y.00025 5 $2 million. The NPV is thus $2.4 million 2 $2 million 5 $400,000, and the system appears to be desirable.

Alternatively, Atlantic could invest the $2.4 million at .025 percent per day. The interest earned would be $2.4 million 3 .00025 5 $600 per day. The cost of the system is $500 per day; so running it obviously generates a profit in the amount of $100 per day. The PV of $100 per day forever is $100y.00025 5 $400,000, just as we calculated before.

Finally, and most simply, each check is for $600 and is available two days sooner if the system is used. The interest on $600 for two days is 2 3 $600 3 .00025 5 $.30. The cost is 25 cents per check, so Atlantic makes a nickel (5$.30 2 .25) on every check. With 2,000 checks per day, the profit is $.05 3 2,000 checks 5 $100 per day, as we previously calculated.

EXAMPLE 27.4 Accelerating Collections In our example concerning the Atlantic Corporation’s proposed lock-

box system, suppose Pacific Bank wants a $20,000 fixed fee (paid annually) in addition to the 25 cents per check. Is the system still a good idea?

To answer, we need to calculate the PV of the fixed fee. The daily interest rate is .025 percent. The annual rate is therefore 1.00025365 2 1 5 9.553%. The PV of the fixed fee (which is paid each year forever) is $20,000y.09553 5 $209,358. Because the NPV without the fee is $400,000, the NPV with the fee is $400,000 2 $209,358 5 $190,642. It’s still a good idea.

Managing Cash Disbursements From the firm’s point of view, disbursement float is desirable, so the goal in managing disbursement float is to slow down disbursements. To do this, the firm may develop strate- gies to increase mail float, processing float, and availability float on the checks it writes. Beyond this, firms have developed procedures for minimizing cash held for payment purposes. We discuss the most common of these in this section.

INCREASING DISBURSEMENT FLOAT As we have seen, slowing down payments comes from the time involved in mail delivery, check processing, and collection of funds. Disbursement float can be increased by writ- ing a check on a geographically distant bank. For example, a New York supplier might be paid with checks drawn on a Los Angeles bank. This will increase the time required for the checks to clear through the banking system. Mailing checks from remote post offices is another way firms slow down disbursement.

Tactics for maximizing disbursement float are debatable on both ethical and economic grounds. First, as we discuss in some detail in the next chapter, payment terms frequently offer a substantial discount for early payment. The discount is usually much larger than any possible savings from “playing the float game.” In such cases, increasing mailing time will be of no benefit if the recipient dates payments based on the date received (as is common) as opposed to the postmark date.

27.4

For a free cash budgeting spreadsheet, go to www.bizfilings.com /toolkit/tools-forms .aspx.

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CHAPTER 27 Cash Management ■■■ 843

Beyond this, suppliers are not likely to be fooled by attempts to slow down dis- bursements. The negative consequences of poor relations with suppliers can be costly. In broader terms, intentionally delaying payments by taking advantage of mailing times or unsophisticated suppliers may amount to avoiding paying bills when they are due—an unethical business procedure.

CONTROLLING DISBURSEMENTS We have seen that maximizing disbursement float is probably a poor business practice. However, a firm will still wish to tie up as little cash as possible in disbursements. Firms have therefore developed systems for efficiently managing the disbursement process. The general idea in such systems is to have no more than the minimum amount necessary to pay bills on deposit in the bank. We discuss some approaches to accomplishing this goal next.

Zero-Balance Accounts With a zero-balance account system, the firm, in cooperation with its bank, maintains a master account and a set of subaccounts. When a check written on one of the subaccounts must be paid, the necessary funds are transferred in from the master account. Figure 27.5 illustrates how such a system might work. In this case, the firm maintains two disbursement accounts, one for suppliers and one for payroll. As shown, if the firm does not use zero-balance accounts, then each of these accounts must have a safety stock of cash to meet unanticipated demands. If the firm does use zero- balance accounts, then it can keep one safety stock in a master account and transfer the funds to the two subsidiary accounts as needed. The key is that the total amount of cash held as a buffer is smaller under the zero-balance arrangement, which frees up cash to be used elsewhere.

Controlled Disbursement Accounts With a controlled disbursement account system, almost all payments that must be made in a given day are known in the morning. The bank informs the firm of the total, and the firm transfers (usually by wire) the amount needed.

Figure 27.5 Zero-Balance Accounts

No zero-balance accounts Payroll account Supplier account

Two zero-balance accounts Master account

Safety stock

Cash transfers

Cash transfers

Payroll account Supplier account

With no zero-balance accounts, separate safety stocks must be maintained, which ties up cash unnecessarily. With zero- balance accounts, the firm keeps a single safety stock of cash in a master account. Funds are transferred into disbursement accounts as needed.

Safety stocks

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844 ■■■ PART VII Short-Term Finance

Investing Idle Cash If a firm has a temporary cash surplus, it can invest in short-term securities. As we have men- tioned at various times, the market for short-term financial assets is called the money market. The maturity of short-term financial assets that trade in the money market is one year or less.

Most large firms manage their own short-term financial assets, carrying out transac- tions through banks and dealers. Some large firms and many small firms use money market mutual funds. These are funds that invest in short-term financial assets for a management fee. The management fee is compensation for the professional expertise and diversification provided by the fund manager.

Among the many money market mutual funds, some specialize in corporate custom- ers. In addition, banks offer arrangements in which the bank takes all excess available funds at the close of each business day and invests them for the firm.

TEMPORARY CASH SURPLUSES Firms have temporary cash surpluses for various reasons. Two of the most important are the financing of seasonal or cyclical activities of the firm and the financing of planned or possible expenditures.

Seasonal or Cyclical Activities Some firms have a predictable cash flow pat- tern. They have surplus cash flows during part of the year and deficit cash flows the rest of the year. For example, Toys “ ” Us, a retail toy firm, has a seasonal cash flow pattern influenced by the holiday season.

A firm such as Toys “ ” Us may buy marketable securities when surplus cash flows occur and sell marketable securities when deficits occur. Of course, bank loans are another short-term financing device. The use of bank loans and marketable securities to meet tempo- rary financing needs is illustrated in Figure 27.6. In this case, the firm is following a compro- mise working capital policy in the sense we discussed in the previous chapter.

27.5

Figure 27.6 Seasonal Cash

Demands

Time (quarters)

Total financing needsBank

loans Marketable securities

Short-term financing

Long-term financing

Time 1: A surplus cash flow exists. Seasonal demand for assets is low. The surplus cash flow is invested in short-term marketable securities. Time 2: A deficit cash flow exists. Seasonal demand for assets is high. The financial deficit is financed by selling marketable securities and by bank borrowing.

Do lla

rs

0 1 2 3

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CHAPTER 27 Cash Management ■■■ 845

Planned or Possible Expenditures Firms frequently accumulate temporary investments in marketable securities to provide the cash for a plant construction pro- gram, dividend payment, or other large expenditure. Thus, firms may issue bonds and stocks before the cash is needed, investing the proceeds in short-term marketable securi- ties and then selling the securities to finance the expenditures. Also, firms may face the possibility of having to make a large cash outlay. An obvious example would involve the possibility of losing a large lawsuit. Firms may build up cash surpluses against such a contingency.

CHARACTERISTICS OF SHORT-TERM SECURITIES Given that a firm has some temporarily idle cash, a variety of short-term securities are available for investing. The most important characteristics of these short-term marketable securities are their maturity, default risk, marketability, and taxability.

Maturity From Chapter 8, we know that for a given change in the level of interest rates, the prices of longer-maturity securities will change more than those of shorter- maturity securities. As a consequence, firms that invest in long-term securities are accept- ing greater risk than firms that invest in securities with short-term maturities.

We called this type of risk interest rate risk. Firms often limit their investments in market- able securities to those maturing in less than 90 days to avoid the risk of losses in value from changing interest rates. Of course, the expected return on securities with short-term maturities is usually less than the expected return on securities with longer maturities.

Default Risk Default risk refers to the probability that interest and principal will not be paid in the promised amounts on the due dates (or will not be paid at all). In Chapter 8, we observed that various financial reporting agencies, such as Moody’s Investors Service and Standard and Poor’s, compile and publish ratings of various corporate and other pub- licly held securities. These ratings are connected to default risk. Of course, some securities have negligible default risk, such as U.S. Treasury bills. Given the purposes of investing idle corporate cash, firms typically avoid investing in marketable securities with significant default risk.

Marketability Marketability refers to how easy it is to convert an asset to cash; so marketability and liquidity mean much the same thing. Some money market instruments are much more marketable than others. At the top of the list are U.S. Treasury bills, which can be bought and sold very cheaply and very quickly.

Taxes Interest earned on money market securities that are not some kind of govern- ment obligation (either federal or state) is taxable at the local, state, and federal levels. U.S. Treasury obligations such as T-bills are exempt from state taxation, but other government- backed debt is not. Municipal securities are exempt from federal taxes, but they may be taxed at the state level.

SOME DIFFERENT TYPES OF MONEY MARKET SECURITIES Money market securities are generally highly marketable and short-term. They usually have low risk of default. They are issued by the U.S. government (e.g., U.S. Treasury bills), domestic and foreign banks (e.g., certificates of deposit), and business corporations (e.g., commercial paper). There are many types in all, and we illustrate only a few of the most common here.

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846 ■■■ PART VII Short-Term Finance

U.S. Treasury bills are obligations of the U.S. government that mature in 30, 90, or 180 days. Bills are sold by auction every week.

Short-term tax-exempts are short-term securities issued by states, municipalities, local housing agencies, and urban renewal agencies. Because these are all considered municipal securities, they are exempt from federal taxes. RANs, BANs, and TANs, for example, are revenue, bond, and tax anticipation notes, respectively. In other words, they represent short-term borrowing by municipalities in anticipation of cash receipts.

Short-term tax-exempts have more default risk than U.S. Treasury issues and are less marketable. Because the interest is exempt from federal income tax, the pretax yield on tax-exempts is lower than that on comparable securities such as Treasury bills. Also, cor- porations face restrictions on holding tax-exempts as investments.

Commercial paper consists of short-term securities issued by finance companies, banks, and corporations. Typically, commercial paper is unsecured. Maturities range from a few weeks to 270 days.

There is no especially active secondary market in commercial paper. As a consequence, the marketability can be low; however, firms that issue commercial paper will often repurchase it directly before maturity. The default risk of commercial paper depends on the financial strength of the issuer. Moody’s and S&P publish quality ratings for commercial paper. These ratings are similar to the bond ratings we discussed in Chapter 8.

Certificates of deposit (CDs) are short-term loans to commercial banks. The most common are jumbo CDs—those in excess of $100,000. There are active markets in CDs of 3-month, 6-month, 9-month, and 12-month maturities.

Repurchase agreements (repos) are sales of government securities (e.g., U.S. Treasury bills) by a bank or securities dealer with an agreement to repurchase. Typically, an investor buys some Treasury securities from a bond dealer and simultaneously agrees to sell them back at a later date at a specified higher price. Repurchase agreements usually involve a very short term—overnight to a few days.

Because 70 to 80 percent of the dividends received by one corporation from another are exempt from taxation, the relatively high dividend yields on preferred stock provide a strong incentive for investment. The only problem is that the dividend is fixed with ordinary preferred stock, so the price can fluctuate more than is desirable in a short-term investment. However, money market preferred stock is a fairly recent innovation featuring a floating dividend. The dividend is reset fairly often (usually every 49 days); so this type of preferred has much less price volatility than ordinary preferred, and it has become a popular short-term investment.

Check out short-term rates online at www.bloomberg .com.

Summary and Conclusions In this chapter, we have examined cash and liquidity management. We saw the following:

1. A firm holds cash to conduct transactions and to compensate banks for the various services they render.

2. The difference between a firm’s available balance and its book balance is the firm’s net float. The float reflects the fact that some checks have not cleared and are thus uncollected. The financial manager must always work with collected cash balances and not with the company’s book balance. To do otherwise is to use the bank’s cash without the bank knowing it, which raises ethical and legal questions.

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CHAPTER 27 Cash Management ■■■ 847

3. The firm can make use of a variety of procedures to manage the collection and disbursement of cash in such a way as to speed up the collection of cash and slow down the payments. Some methods to speed up the collection are the use of lockboxes, concentration banking, and wire transfers.

4. Because of seasonal and cyclical activities, to help finance planned expenditures, or as a contingency reserve, firms temporarily hold a cash surplus. The money market offers a variety of possible vehicles for “parking” this idle cash.

Concept Questions 1. Cash Management Is it possible for a firm to have too much cash? Why would

shareholders care if a firm accumulates large amounts of cash?

2. Cash Management What options are available to a firm if it believes it has too much cash? How about too little?

3. Agency Issues Are stockholders and creditors likely to agree on how much cash a firm should keep on hand?

4. Cash Management versus Liquidity Management What is the difference between cash management and liquidity management?

5. Short-Term Investments Why is a preferred stock with a dividend tied to short-term interest rates an attractive short-term investment for corporations with excess cash?

6. Collection and Disbursement Floats Which would a firm prefer: A net collection float or a net disbursement float? Why?

7. Float Suppose a firm has a book balance of $2 million. At the automatic teller machine (ATM), the cash manager finds out that the bank balance is $2.5 million. What is the situation here? If this is an ongoing situation, what ethical dilemma arises?

8. Short-Term Investments For each of the short-term marketable securities given here, provide an example of the potential disadvantages the investment has for meeting a corporation’s cash management goals:

a. U.S. Treasury bills. b. Ordinary preferred stock. c. Negotiable certificates of deposit (NCDs). d. Commercial paper. e. Revenue anticipation notes. f. Repurchase agreements.

9. Agency Issues It is sometimes argued that excess cash held by a firm can aggravate agency problems (discussed in Chapter 1) and, more generally, reduce incentives for shareholder wealth maximization. How would you describe the issue here?

10. Use of Excess Cash One option a firm usually has with any excess cash is to pay its suppliers more quickly. What are the advantages and disadvantages of this use of excess cash?

11. Use of Excess Cash Another option usually available is to reduce the firm’s outstanding debt. What are the advantages and disadvantages of this use of excess cash?

12. Float An unfortunately common practice goes like this (Warning: Don’t try this at home): Suppose you are out of money in your checking account; however, your local grocery store will, as a convenience to you as a customer, cash a check for you. So, you cash a check for $200. Of course, this check will bounce unless you do something. To prevent this, you go to the grocery the next day and cash another check

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848 ■■■ PART VII Short-Term Finance

for $200. You take this $200 and deposit it. You repeat this process every day, and, in doing so, you make sure that no checks bounce. Eventually, manna from heaven arrives (perhaps in the form of money from home), and you are able to cover your outstanding checks.

To make it interesting, suppose you are absolutely certain that no checks will bounce along the way. Assuming this is true, and ignoring any question of legality (what we have described is probably illegal check kiting), is there anything unethical about this? If you say yes, then why? In particular, who is harmed?

Questions and Problems 1. Calculating Float In a typical month, the Warren Corporation receives 140 checks

totaling $113,500. These are delayed four days on average. What is the average daily float?

2. Calculating Net Float Each business day, on average, a company writes checks totaling $14,400 to pay its suppliers. The usual clearing time for the checks is four days. Meanwhile, the company is receiving payments from its customers each day, in the form of checks, totaling $25,300. The cash from the payments is available to the firm after two days.

a. Calculate the company’s disbursement float, collection float, and net float. b. How would your answer to part (a) change if the collected funds were available in

one day instead of two?

3. Costs of Float Purple Feet Wine, Inc., receives an average of $13,800 in checks per day. The delay in clearing is typically three days. The current interest rate is .018 percent per day.

a. What is the company’s float? b. What is the most the company should be willing to pay today to eliminate its float

entirely? c. What is the highest daily fee the company should be willing to pay to eliminate its

float entirely?

4. Float and Weighted Average Delay Your neighbor goes to the post office once a month and picks up two checks, one for $9,700 and one for $2,600. The larger check takes four days to clear after it is deposited; the smaller one takes five days.

a. What is the total float for the month? b. What is the average daily float? c. What are the average daily receipts and weighted average delay?

5. NPV and Collection Time Your firm has an average receipt size of $119. A bank has approached you concerning a lockbox service that will decrease your total collection time by two days. You typically receive 5,650 checks per day. The daily interest rate is .015 percent. If the bank charges a fee of $160 per day, should the lockbox project be accepted? What would the net annual savings be if the service were adopted?

6. Using Weighted Average Delay A mail-order firm processes 5,450 checks per month. Of these, 70 percent are for $55 and 30 percent are for $80. The $55 checks are delayed two days on average; the $80 checks are delayed three days on average.

a. What is the average daily collection float? How do you interpret your answer? b. What is the weighted average delay? Use the result to calculate the average

daily float. c. How much should the firm be willing to pay to eliminate the float?

BASIC (Questions 1–10)

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CHAPTER 27 Cash Management ■■■ 849

d. If the interest rate is 7 percent per year, calculate the daily cost of the float. e. How much should the firm be willing to pay to reduce the weighted average float by

1.5 days?

7. Value of Lockboxes Paper Submarine Manufacturing is investigating a lockbox system to reduce its collection time. It has determined the following:

Average number of payments per day 410

Average value of payment $865

Variable lockbox fee (per transaction) $.50

Daily interest rate on money market securities .02%

The total collection time will be reduced by three days if the lockbox system is adopted.

a. What is the PV of adopting the system? b. What is the NPV of adopting the system? c. What is the net cash flow per day from adopting? Per check?

8. Lockboxes and Collections It takes Cookie Cutter Modular Homes, Inc., about five days to receive and deposit checks from customers. Cookie Cutter’s management is considering a lockbox system to reduce the firm’s collection times. It is expected that the lockbox system will reduce receipt and deposit times to three days total. Average daily collections are $126,500, and the required rate of return is 9 percent per year.

a. What is the reduction in outstanding cash balance as a result of implementing the lockbox system?

b. What is the dollar return that could be earned on these savings? c. What is the maximum monthly charge Cookie Cutter should pay for this lockbox

system if the payment is due at the end of the month? What if the payment is due at the beginning of the month?

9. Value of Delay No More Pencils, Inc., disburses checks every two weeks that average $61,700 and take seven days to clear. How much interest can the company earn annually if it delays transfer of funds from an interest-bearing account that pays .015 percent per day for these seven days? Ignore the effects of compounding interest.

10. NPV and Reducing Float No More Books Corporation has an agreement with Floyd Bank, whereby the bank handles $2.9 million in collections a day and requires a $350,000 compensating balance. No More Books is contemplating canceling the agreement and dividing its eastern region so that two other banks will handle its business. Banks A and B will each handle $1.45 million of collections a day, and each requires a compensating balance of $190,000. No More Books’ financial management expects that collections will be accelerated by one day if the eastern region is divided. Should the company proceed with the new system? What will be the annual net savings? Assume that the T-bill rate is 5 percent annually.

11. Lockboxes and Collection Time Bird’s Eye Treehouses, Inc., a Kentucky company, has determined that a majority of its customers are located in the Pennsylvania area. It therefore is considering using a lockbox system offered by a bank located in Pittsburgh. The bank has estimated that use of the system will reduce collection time by two days. Based on the following information, should the lockbox system be adopted?

INTERMEDIATE (Questions 11–12)

Average number of payments per day 850

Average value of payment $630

Variable lockbox fee (per transaction) $.22

Annual interest rate on money market securities 7%

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850 ■■■ PART VII Short-Term Finance

How would your answer change if there were a fixed charge of $5,000 per year in addition to the variable charge?

12. Calculating Transactions Required Cow Chips, Inc., a large fertilizer distributor based in California, is planning to use a lockbox system to speed up collections from its customers located on the East Coast. A Philadelphia-area bank will provide this service for an annual fee of $12,000 plus 10 cents per transaction. The estimated reduction in collection and processing time is one day. If the average customer payment in this region is $4,800, how many customers are needed, on average, each day to make the system profitable for Cow Chips? Treasury bills are currently yielding 5 percent per year.

CASH MANAGEMENT AT RICHMOND CORPORATION Richmond Corporation was founded 20 years ago by its president, Daniel Richmond. The company originally began as a mail-order company but has grown rapidly in recent years, in large part due to its website. Because of the wide geographical dispersion of the company’s customers, it currently employs a lockbox system with collection centers in San Francisco, St. Louis, Atlanta, and Boston.

Steve Dennis, the company’s treasurer, has been examining the current cash collection policies. On average, each lockbox center handles $185,000 in payments each day. The com- pany’s current policy is to invest these payments in short-term marketable securities daily at the collection center banks. Every two weeks the investment accounts are swept, and the proceeds are wire-transferred to Richmond’s headquarters in Dallas to meet the company’s payroll. The investment accounts each pay .068 percent per day, and the wire transfers cost .20 percent of the amount transferred.

Steve has been approached by Third National Bank, located just outside Dallas, about the possibility of setting up a concentration banking system for Richmond Corp. Third National will accept the lockbox centers’ daily payments via automated clearinghouse (ACH) transfers in lieu of wire transfers. The ACH-transferred funds will not be available for use for one day. Once cleared, the funds will be deposited in a short-term account, which will yield .075 percent per day. Each ACH transfer will cost $200. Daniel has asked Steve to determine which cash management system will be the best for the company. Steve has asked you, his assistant, to answer the following questions:

1. What is Richmond Corporation’s total net cash flow from the current lockbox system available to meet payroll?

2. Under the terms outlined by Third National Bank, should the company proceed with the concentration banking system?

3. What cost of ACH transfers would make the company indifferent between the two systems?

Mini Case

Determining the Target Cash Balance

Adjustable Rate Preferred Stock, Auction Rate Preferred Stock, and Floating-Rate Certificates of Deposit To access the appendixes for this chapter, please logon to Connect Finance.

Appendix 27A

Appendix 27B 

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923923

Building casinos in Atlantic City turned out to be a bad bet for many. During 2014, four of the city’s 12 casinos folded, including the Revel. The Revel was unique in that it cost $2.4 billion to build, opened on April 2, 2012, filed for bank- ruptcy in February 2013, and then filed bankruptcy again in September 2014. So, the Revel filed two bankruptcies within two and a half years of first opening! A fifth casino in Atlantic City, the Trump Taj Mahal, barely escaped the same fate after billionaire Carl Icahn put up $20 million to keep its roulette wheels spinning. Then, in January 2015, Caesars Entertainment filed bankruptcy. The Caesars bankruptcy included Caesars Palace Las Vegas, two casinos in Atlantic City, and a dozen Harrah’s or Horseshoe casinos in smaller U.S. markets such as Tunica, Mississippi, and Reno, Nevada.

These bankruptcies are examples of companies expe- riencing significant financial distress, the subject of this chapter. A firm with insufficient cash flow to make con- tractually required financial obligations, such as interest payments, is in financial distress. A firm that defaults on a required payment may be forced to liquidate its assets, but, more often, a defaulting firm will reorganize its finan- cial structure. Financial restructuring involves replacing old financial claims with new ones and takes place with private workouts or legal bankruptcy. Private workouts are volun- tary arrangements to restructure a company’s debt, such as postponing a payment or reducing the size of the payment. If a private workout is not possible, formal bankruptcy is usually required.

Financial Distress

30

What Is Financial Distress? Financial distress is surprisingly hard to define precisely. This is true partly because of the variety of events befalling firms under financial distress. The list of events is almost endless, but here are some examples:

Dividend reductions

Plant closings

Losses

Layoffs

CEO resignations

Plummeting stock prices

Financial distress is a situation where a firm’s operating cash flows are not sufficient to satisfy current obligations (such as trade credits or interest expenses) and the firm is

30.1

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924 ■■■ PART VIII Special Topics

forced to take corrective action.1 Financial distress may lead a firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its equity investors. Usually the firm is forced to take actions that it would not have taken if it had sufficient cash flow.

Our definition of financial distress can be expanded somewhat by linking it to insol- vency. Insolvency is defined in Black’s Law Dictionary as:2

Inability to pay one’s debts; lack of means of paying one’s debts. Such a condition of a woman’s (or man’s) assets and liabilities that the former made immediately available would be insufficient to discharge the latter.

This definition has two general themes: stocks and flows.3 These two ways of thinking about insolvency are depicted in Figure 30.1. Stock-based insolvency occurs when a firm has negative net worth, so the value of assets is less than the value of its debts. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations. Flow-based insolvency refers to the inability to pay one’s debts. Insolvency may lead to bankruptcy. Some of the largest U.S. bankruptcies are in Table 30.1. 1This definition is close to the one used by Karen Wruck, “Financial Distress, Reorganization, and Organizational Efficiency,” Journal of Financial Economics 27 (1990), p. 425. 2Taken from Black’s Law Dictionary, 5th ed. (St. Paul, MN: West Publishing Company), p. 716. 3Edward Altman was one of the first to distinguish between stock-based insolvency and flow-based insolvency. See Edward Altman, Corporate Financial Distress: A Complete Guide to Predicting, Avoiding, and Dealing with Bankruptcy, 2nd ed. (New York: John Wiley & Sons, 1993).

A. Stock-based insolvency

Solvent firm Insolvent firm

Debt

Equity Negative equity

B. Flow-based insolvency

A s s e t s

A s s e t s

D e b t

$

Contractual obligations

Firm cash flow

Cash flow shortfall

Insolvency Stock-based insolvency occurs when the value of the assets of a firm is less than the value of the debts. This implies negative equity. Flow-based insolvency occurs when firm cash flows are insufficient to cover contractually required payments.

Figure 30.1 Insolvency

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CHAPTER 30 Financial Distress ■■■ 925

What Happens in Financial Distress? In June 2008, General Motors (GM) reported second quarter net income of negative $15 million. It also lost money in 2005 and 2007 and steadily lost its market share to rivals such as Toyota, BMW, and Honda. Its accounting shareholder equity turned nega- tive in 2006 and its stock price decreased from $50 in late 2003 to about $1 in 2009. Automobile customers had good reason to worry about buying cars from GM. GM struggled to increase sales, cut costs, attempted to sell assets (e.g., the Hummer line), drew down bank debt, and arranged for more long-term financing. GM was clearly a firm experiencing financial distress. GM filed for bankruptcy on June 1, 2009. GM emerged from bankruptcy six weeks later and shares of GM were sold in the world’s largest IPO (at the time) in November 2010. Most of the shares were owned by the U.S. Treasury in what had been one of the biggest “bail outs” of a private firm by the U.S. Treasury. GM began paying cash dividends in 2014 and has five consecutive years of positive cash flow. Of course, many firms experiencing financial distress and bankruptcy do not fare as well as GM.

Firms deal with financial distress in several ways, such as these:

1. Selling major assets.

2. Merging with another firm.

3. Reducing capital spending and research and development.

4. Issuing new securities.

5. Negotiating with banks and other creditors.

6. Exchanging debt for equity.

7. Filing for bankruptcy.

Items (1), (2), and (3) concern the firm’s assets. Items (4), (5), (6), and (7) involve the right side of the firm’s balance sheet and are examples of financial restructuring. Financial

30.2

Firm Liabilities

($ in millions) Bankruptcy Date

1 Lehman Brothers Holdings, Inc. $613,000.00 15-Sep-08

2 General Motors Corp. 172,810.00 01-Jun-09

3 CIT Group, Inc. 64,901.20 01-Nov-09

4 Conseco, Inc. 56,639.30 02-Dec-02

5 Chrysler, LLC 55,200.00 30-Apr-09

6 WorldCom, Inc. 45,984.00 21-Jul-02

7 MF Global Holdings Ltd. 39,683.92 31-Oct-11

8 Refco, Inc. 33,300.00 05-Oct-05

9 Enron Corp. 31,237.00 02-Dec-01

10 Delta Air Lines, Inc. 28,546.00 05-Sep-05

SOURCE: Supplied by Edward I. Altman, NYU Salomon Center, Stern School of Business.

Table 30.1 Large U.S.

Bankruptcies

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926 ■■■ PART VIII Special Topics

distress may involve both asset restructuring and financial restructuring (i.e., changes on both sides of the balance sheet).

Some firms may actually benefit from financial distress by restructuring their assets. For example, a levered recapitalization can change a firm’s behavior and force a firm to dispose of unrelated businesses. A firm going through a levered recapi- talization will add a great deal of debt and, as a consequence, its cash flow may not be sufficient to cover required payments, and it may be forced to sell its noncore businesses. For some firms, financial distress may bring about new organizational forms and new operating strategies. However, in this chapter we focus on financial restructuring.

Financial restructuring may occur in a private workout or a bankruptcy reorganiza- tion under Chapter 11 of the U.S. bankruptcy code. Figure 30.2 shows how large public firms move through financial distress. Approximately half of the financial restructur- ings have been done via private workouts. Most large public firms (approximately 83 percent) that file for Chapter 11 bankruptcy are able to reorganize and continue to do business.4

Financial distress can serve as a firm’s “early warning” system for trouble. Firms with more debt will experience financial distress earlier than firms with less debt. However, firms that experience financial distress earlier will have more time for private workouts and reorganization. Firms with low leverage will experience financial distress later and, in many instances, be forced to liquidate.

4However, less than 20 percent of all firms (public or private) going through a Chapter 11 bankruptcy are successfully reorganized.

Figure 30.2 What Happens in

Financial Distress with Large Public Firms

No financial restructuring

Financial distress

Private workout

Financial restructuring

Reorganize and emerge

Legal bankruptcy Chapter 11

Merge with another firm

Liquidation

49%

47%

83%

7%

10%

53%

51%

SOURCE: Karen H. Wruck, “Financial Distress, Reorganization, and Organizational Efficiency,” Journal of Financial Economics 27 (1990), Figure 2. See also Stuart C. Gilson, Kose John, and Larry H. P. Lang, “Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default,” Journal of Financial Economics 27 (1990); and Lawrence A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics 27 (1990).

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CHAPTER 30 Financial Distress ■■■ 927

Bankruptcy Liquidation and Reorganization Firms that cannot or choose not to make contractually required payments to creditors have two basic options: Liquidation or reorganization. This section discusses bankruptcy liquidation and reorganization.5

Liquidation means termination of the firm as a going concern; it involves selling the assets of the firm for salvage value. The proceeds, net of transactions costs, are distributed to creditors in order of established priority.

Reorganization is the option of keeping the firm a going concern; it sometimes involves issuing new securities to replace old securities.

Liquidation and formal reorganization may be done by bankruptcy. Bankruptcy is a legal proceeding and can be done voluntarily with the corporation filing the petition or involuntarily with the creditors filing the petition.

BANKRUPTCY LIQUIDATION Chapter 7 of the Bankruptcy Reform Act of 1978 deals with “straight” liquidation. The following sequence of events is typical:

1. A petition is filed in a federal court. A corporation may file a voluntary petition, or involuntary petitions may be filed against the corporation.

2. A bankruptcy trustee is elected by the creditors to take over the assets of the debtor corporation. The trustee will attempt to liquidate the assets.

3. When the assets are liquidated, after payment of the costs of administration, pro- ceeds are distributed among the creditors.

4. If any assets remain after expenses and payments to creditors, they are distributed to the shareholders.

Conditions Leading to Involuntary Bankruptcy An involuntary bank- ruptcy petition may be filed by creditors if both the following conditions are met:

1. The corporation is not paying debts as they become due.

2. If there are more than 12 creditors, at least three with claims totaling $13,475 or more must join in the filing. If there are fewer than 12 creditors, then only one with a claim of $13,475 is required to file.

Priority of Claims Once a corporation is determined to be bankrupt, liquidation takes place. The distribution of the proceeds of the liquidation occurs according to the following priority:

1. Administration expenses associated with liquidating the bankrupt company’s assets.

2. Unsecured claims arising after the filing of an involuntary bankruptcy petition.

3. Wages, salaries, and commissions.

4. Contributions to employee benefit plans arising within 180 days before the filing date.

30.3

5One of the most important choices a bankrupt firm must make is whether to liquidate or reorganize. Arturo Bris, Ivo Welch, and Ning Zhu have looked closely at this choice in “The Costs of Bankruptcy: Chapter 7 Liquidation versus Chapter 11 Reorganization,” Journal of Finance (June 2006). They find:

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5. Consumer claims.

6. Tax claims.

7. Secured and unsecured creditors’ claims.

8. Preferred stockholders’ claims.

9. Common stockholders’ claims.

The priority rule in liquidation is the absolute priority rule (APR). One qualification to this list concerns secured creditors. Liens on property are outside

APR ordering. However, if the secured property is liquidated and provides cash insufficient to cover the amount owed them, the secured creditors join with unsecured creditors in dividing the remaining liquidating value. In contrast, if the secured property is liquidated for proceeds greater than the secured claim, the net proceeds are used to pay unsecured creditors and others.

EXAMPLE 30.1 APR The B. O. Drug Company is to be liquidated. Its liquidating value is $2.7 million. Bonds worth

$1.5 million are secured by a mortgage on the B.O. Drug Company corporate headquarters building, which is sold for $1 million; $200,000 is used to cover administrative costs and other claims (including unpaid wages, pension benefits, consumer claims, and taxes). After paying $200,000 to the adminis- trative priority claims, the amount available to pay secured and unsecured creditors is $2.5 million. This is less than the amount of unpaid debt of $4 million.

Under APR, all creditors must be paid before shareholders, and the mortgage bondholders have first claim on the $1 million obtained from the sale of the headquarters building.

The trustee has proposed the following distribution:

Type of Claim Prior Claim Cash Received

under Liquidation

Bonds (secured by mortgage) $ 1,500,000 $1,500,000 Subordinated debentures 2,500,000 1,000,000 Common stockholders 10,000,000 0 Total $14,000,000 $2,500,000

Calculation of the Distribution

Cash received from sale of assets available for distribution $2,500,000 Cash paid to secured bondholders on sale of mortgaged property 1,000,000 Available to bond and debenture holders $1,500,000 Total claims remaining ($4,000,000 less payment of $1,000,000 on secured bonds) $3,000,000 Distribution of remaining $1,500,000 to cover total remaining claims of $3,000,000

Type of Claim Remaining

Claim on Liquidation Proceeds Cash Received

Bonds $ 500,000 $ 500,000 Debentures 2,500,000 1,000,000

Total $3,000,000 $1,500,000

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BANKRUPTCY REORGANIZATION Corporate reorganization takes place under Chapter 11 of the Federal Bankruptcy Reform Act of 1978, as amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.6 The general objective of a proceeding under Chapter 11 is to plan to restruc- ture the corporation with some provision for repayment of creditors. A typical sequence of events follows:

1. A voluntary petition can be filed by the corporation, or an involuntary petition can be filed by three or more creditors (or one creditor if the total creditors are fewer than 12—see the previous section). The involuntary petition must allege that the cor- poration is not paying its debts.

2. Usually, a federal judge approves the petition, and a time for filing proofs of claims of creditors and of shareholders is set.

3. In most cases, the corporation (the “debtor in possession”) continues to run the business.7

4. For 120 days only the corporation can file a reorganization plan. If it does, the corporation is given 180 days from the filing date to gain acceptance of the plan.

5. Creditors and shareholders are divided into classes. A class of creditors accepts the plan if two-thirds of the class (in dollar amount) and one-half of the class (in number) have indicated approval.8

6. After acceptance by creditors, the plan is confirmed by the court.

7. Payments in cash, property, and securities are made to creditors and shareholders. The plan may provide for the issuance of new securities.

Recently, Section 363 of the bankruptcy code has been in the news. In a traditional Chapter 11 filing, the bankruptcy plan is described to creditors and shareholders in a prospectus-like disclosure. The plan must then be approved in a vote by the interested parties. A Section 363 bankruptcy is more like an auction. An initial bidder, known as a “stalking horse,” bids on all or part of the bankrupt company’s assets. Other bidders are then invited into the process in an attempt to produce the highest possible bid. The main advantage of a Section 363 bankruptcy is speed. Since a traditional bankruptcy requires the approval of interested parties, it is not uncommon for the process to take several years, while a Section 363 bankruptcy is generally much quicker. For example, in the middle of 2009, both General Motors and Chrysler sped through the bankruptcy process in less than 45 days because of Section 363 auctions.

6Do bankruptcy codes matter? The answer is yes for Sergei A. Davydenko and Julian R. Franks in “Do Bankruptcy Codes Matter? A Study of Defaults in France, Germany, and the U.K.,” Journal of Finance (April 2008). They find that the different bankruptcy codes of France, Germany, and the U.K. produce different outcomes of financial distress situations even though banks make significant adjustments in response to creditors’ friendly or unfriendly codes, respectively. 7In Chapter 11 bankruptcies, the firm (now called “debtor in possession”) continues to operate. In many cases, the firm will seek to borrow new money and use the proceeds to pay off secured creditors and to continue to operate until a reorganization plan is approved. 8We are describing the standard events in a bankruptcy reorganization. Petitions are almost always accepted, and the general rule is that a reorganization plan will be accepted by the court if all of the creditor classes accept it and it will be rejected if all of the creditor classes reject it. However, if one or more (but not all) of the classes accept it, the plan may be eligible for a “cram down” procedure. A cram down takes place if the bankruptcy court finds a plan fair and equitable and accepts the plan for all creditors.

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930

EDWARD I. ALTMAN* ON CORPORATE FINANCIAL DISTRESS AND BANKRUPTCY

Financial distress of private and public entities through- out the world is a frequent occurrence with important implications for their many stakeholders. While the role of corporate bankruptcy laws is clear—either to provide a legal procedure that permits firms which have temporary liquidity problems to restructure and successfully emerge as continuing entities or to provide an orderly process to liquidate assets for the benefit of creditors before asset values are dissipated—bankruptcy laws differ markedly from country to country. It is generally agreed upon that the U.S. Chapter 11 provisions under the Bankruptcy Reform Act of 1978 provide the most protection for bankrupt firms’ assets and result in a greater likelihood of successful reorganization than is found in other countries where liquidation and sale of the assets for the benefit of creditors is more likely the result. But the U.S. code’s process is usually lengthy (averaging close to two years, except where a sufficient number of creditors agree in advance via a prepackaged Chapter 11) and expensive, and the reorganized entity is not always successful in avoiding subsequent distress. If the reorganization is not successful, then liquidation under Chapter 7 will usually ensue.

Bankruptcy processes in the industrialized world out- side the United States strongly favor senior creditors

who obtain control of the firm and seek to enforce greater adherence to debt contracts. The U.K. process, for example, is speedy and less costly, but the reduced costs can result in undesirable liquidations, unemploy- ment, and underinvestment. The new bankruptcy code in Germany attempts to reduce the considerable power of secured creditors but it is still closer to the U.K. system. In the United States, creditors and owners can negotiate “violations” to the “absolute priority rule”—this “rule” holds that more senior creditors must be paid in full, prior to any payments to more junior creditors or to owners. (However, the so-called “violations” to absolute priority have empirically been shown to be relatively small—such as under 10 percent of firm value.) Finally, the U.S. sys- tem gives the court the right to sanction postpetition debt financing, usually with superpriority status over existing claims, thereby facilitating the continuing operation of the firm. Recently, France had a similar successful experience.

A measure of performance of the U.S. bankruptcy system is the proportion of firms that emerge successfully. The results in the United States of late are somewhat mixed, with close to 83 percent of large firms emerging but probably less than 20 percent of smaller entities. And a not insignificant number of firms suffer subsequent distress and may file again.

Regardless of the location, one of the objectives of bankruptcy and other distressed workout arrangements is

In Their Own Words

EXAMPLE 30.2 Chapter 11 Suppose B.O. Drug Co. decides to reorganize under Chapter 11. Generally senior

claims are honored in full before various other claims receive anything. Assume that the “going con- cern” value of B.O. Drug Co. is $3 million and that its balance sheet is as shown:

Assets $3,000,000 Liabilities Mortgage bonds 1,500,000 Subordinated debentures 2,500,000 Stockholders’ equity −1,000,000

The firm has proposed the following reorganization plan:

Old Security Old Claim New Claim with

Reorganization Plan

Mortgage bonds $1,500,000 $1,500,000 Subordinated debentures 2,500,000 1,500,000

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931

that creditors and other suppliers of capital clearly know their rights and expected recoveries in the event of a dis- tressed situation. When these are not transparent and/or are based on outdated processes with arbitrary and possibly corrupt outcomes, then the entire economic system suffers and growth is inhibited. Such is the case in several emerg- ing market countries. Revision of these outdated systems should be a priority.

In addition to the comparative benefits of different national restructuring systems, a number of intriguing the- oretical and empirical issues are related to the distressed firm. Among these are corporate debt capacity, manager– creditor–owner incentives, ability to predict distress, data and computations for default rate estimation, investment in securities of distressed firms, and post-reorganization performance assessment.

Corporate distress has a major impact on creditor– debtor relationships and, combined with business risk and tax considerations, affects the capital structure of com- panies. One key question is how costly are the expected distress costs compared to the expected tax benefits of using leverage—the so-called trade-off theory. Most ana- lysts agree that the sum of direct (e.g., legal fees) and indirect costs is in the range of 10–20 percent of firm value.

Whether the taking of excess risk and overinvestment are examples of agency conflicts between managers and credi- tors rests upon one’s view as to who are the true residual owners of a distressed firm—the existing equityholders or

creditors who will more than likely be the new owners of a reorganized entity. Existing management has the exclusive right to file the first plan of reorganization within 120 days of filing, with exclusivity extensions possible. Their incen- tives and influence can be biased, however, and not always in accord with other stakeholders, primarily creditors. Limiting this exclusivity would appear to be desirable to speed up the process and restrict managerial abuse.

Distress prediction models have intrigued researchers and practitioners for more than 50 years. Models have evolved from univariate financial statement ratios to mul- tivariate statistical classification models, to contingent claim and market value–based approaches, and finally to using artificial intelligence techniques. Most large financial institutions have one or more of these types of models in place as more sophisticated credit risk man- agement frameworks are being introduced, sometimes combined with aggressive credit asset portfolio strategies. Increasingly, private credit assets are being treated as secu- rities with estimates of default and recovery given default the critical inputs to their valuation.

Perhaps the most intriguing by-product of corporate distress is the development of a relatively new class of investors known as vultures. These money managers spe- cialize in securities of distressed and defaulted companies.

*Edward I. Altman is Max L. Heine Professor of Finance, NYU Stern School of Business. He is widely recognized as one of the world’s experts on bankruptcy and credit analysis, as well as the distressed debt and high-yield bond markets.

The firm has also proposed a distribution of new securities under a new claim with this reorganiza- tion plan:

Old Security Received under Proposed Reorganization Plan

Mortgage bonds $1,000,000 in 9% senior debentures $500,000 in 11% subordinated debentures

Debentures $1,000,000 in 8% preferred stock $500,000 in common stock

However, it will be difficult for the firm to convince secured creditors (mortgage bonds) to accept unsecured debentures of equal face value. In addition, the corporation may wish to allow the old stockholders to retain some participation in the firm. Needless to say, this would be a violation of the absolute priority rule, and the holders of the debentures would not be happy.

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Private Workout or Bankruptcy: Which Is Best? A firm that defaults on its debt payments will need to restructure its financial claims. The firm will have two choices: Formal bankruptcy or private workout. The previous section described two types of formal bankruptcies: Bankruptcy liquidation and bankruptcy reorganization. This section compares private workouts with bankruptcy reorganizations. Both types of financial restructuring involve exchanging new financial claims for old financial claims. Usually, senior debt is replaced with junior debt and junior debt is replaced with equity. Much recent academic research has described what happens in private workouts and formal bankruptcies.9

● Historically, half of financial restructurings have been private, but recently, formal bankruptcies have dominated.

● Firms that emerge from private workouts experience stock price increases that are much greater than those for firms emerging from formal bankruptcies.

● The direct costs of private workouts are much less than the costs of formal bankruptcies. ● Top management usually loses pay and sometimes jobs in both private workouts and

formal bankruptcies.

These facts, when taken together, seem to suggest that a private workout is much better than a formal bankruptcy. We then ask: Why do firms ever use formal bankruptcies to restructure?

30.4

9For example, see Stuart Gilson, “Managing Default: Some Evidence on How Firms Choose between Workouts and Chapter 11,” Journal of Applied Corporate Finance (Summer 1991); and Stuart C. Gilson, Kose John, and Larry H. P. Lang, “Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default,” Journal of Financial Economics 27 (1990).

Absolute Priority Rule (APR) The absolute priority rule states that senior claims are fully satisfied before junior claims receive anything.

Deviation from Rule Equityholders Expectation: No payout

Reality: Payout in 81 percent of cases Unsecured creditors Expectation: Full payout after secured creditors

Secured creditors Expectation: Full payout Reality: Full payout in 92 percent of cases

Reasons for Violations

Creditors want to avoid the expense of litigation. Debtors are given a 120-day opportunity to cause delay and harm value.

Managers often own equity and demand to be compensated. Bankruptcy judges like consensual plans and pressure parties to compromise.

SOURCE: Lawrence A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Journal of Financial Economics 27 (1990).

THE MARGINAL FIRM For the average firm, a formal bankruptcy is more costly than a private workout, but for other firms formal bankruptcy is better. Formal bankruptcy allows firms to issue debt that

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CHAPTER 30 Financial Distress ■■■ 933

is senior to all previously incurred debt. This new debt is “debtor in possession” (DIP) debt. For firms that need a temporary injection of cash, DIP debt makes bankruptcy reor- ganization an attractive alternative to a private workout. There are some tax advantages to bankruptcy. Firms do not lose tax carryforwards in bankruptcy, and the tax treatment of the cancellation of indebtedness is better in bankruptcy. Also, interest on prebankruptcy unsecured debt stops accruing in formal bankruptcy.

HOLDOUTS Bankruptcy is usually better for the equity investors than it is for the creditors. Using DIP debt and stopping prebankruptcy interest from accruing on unsecured debt helps the stockholders and hurts the creditors. As a consequence, equity investors can usually hold out for a better deal in bankruptcy. The absolute priority rule, which favors creditors over equity investors, is usually violated in formal bankruptcies. One recent study found that in 81 percent of recent bankruptcies the equity investor obtained some compensation.10 Under Chapter 11, the creditors are often forced to give up some of their seniority rights to get management and the equity investors to agree to a deal.

COMPLEXITY A firm with a complicated capital structure will have more trouble putting together a pri- vate workout. Firms with secured creditors and trade creditors such as Macy’s and Carter Hawley Hale will usually use formal bankruptcy because it is too hard to reach an agree- ment with many different types of creditors.

LACK OF INFORMATION There is an inherent conflict of interest between equity investors and creditors, and the conflict is accentuated when both have incomplete information about the circumstances of financial distress. When a firm initially experiences a cash flow shortfall, it may not know whether the shortfall is permanent or temporary. If the shortfall is permanent, creditors will push for a formal reorganization or liquidation. However, if the cash flow shortfall is temporary, formal reorganization or liquidation may not be necessary. Equity investors will push for this viewpoint. This conflict of interest cannot easily be resolved.

These last two points are especially important. They suggest that financial distress will be more expensive (cheaper) if complexity is high (low) and information is incom- plete (complete). Complexity and lack of information make cheap workouts less likely.

Prepackaged Bankruptcy11 On March 14, 2014, sub shop Quiznos filed for Chapter 11 reorganization under the U.S. bankruptcy code. At the time, the company listed less than $1 million in assets and more than $500 million in liabilities. A firm in this situation could reasonably expect to spend

30.5

10 Journal of Financial Economics 27 (1990). However, William Beranek, Robert Boehmer, and Brooke Smith, in “Much Ado about Nothing: Absolute Priority Deviations in Chapter 11,” Financial Management (Autumn 1996), find that 33.8 percent of bankruptcy reorganizations leave the stockholders with nothing. They also point out that deviations from the absolute priority rule are to be expected because the bankruptcy code allows creditors to waive their rights if they perceive a waiver to be in their best interests. A rejoinder can be found in Allan C. Eberhart and Lawrence A. Weiss, “The Importance of Deviations from the Absolute Priority Rule in Chapter 11 Bankruptcy Proceedings,” Financial Management 27 (1998). 11John McConnell and Henri Servaes, “The Economics of Prepackaged Bankruptcy,” Journal of Applied Corporate Finance (Summer 1991), describe prepackaged bankruptcy.

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a year or more in bankruptcy. Not so with Quiznos group. Its reorganization plan was confirmed by the U.S. Bankruptcy Court on July 1, 2014, less than four months after the date of the filing!

Firms typically file bankruptcy to seek protection from their creditors, essentially admitting that they cannot meet their financial obligations as they are presently struc- tured. Once in bankruptcy, the firm attempts to reorganize its financial picture so that it can survive. A key to this process is that the creditors must ultimately give their approval to the restructuring plan. The time a firm spends in Chapter 11 depends on many things, but it usually depends most on the time it takes to get creditors to agree to a plan of reorganization.

Prepackaged bankruptcy is a combination of a private workout and legal bank- ruptcy. Prior to filing bankruptcy, the firm approaches its creditors with a plan for reorganization. The two sides negotiate a settlement and agree on the details of how the firm’s finances will be restructured in bankruptcy. Then, the firm puts together the necessary paperwork for the bankruptcy court before filing for bankruptcy. A filing is a prepack if the firm walks into court and, at the same time, files a reorganization plan complete with the documentation of the approval of its creditors, which is exactly what Quiznos did.

The key to the prepackaged reorganization process is that both sides have something to gain and something to lose. If bankruptcy is imminent, it may make sense for the creditors to expedite the process even though they are likely to take a financial loss in the restructuring. Quiznos’ bankruptcy was painful for both stockholders and bondholders. Under the terms of the agreement, stockholders were wiped out entirely and three senior lenders exchanged $445 million in debt for 70 percent of the equity in the company and $200 million in new debt.

In another example of a prepack, let’s go back to the Atlantic City casino Revel we mentioned in our opener. Recall that it closed its doors in September 2014. On February 19, 2013, Revel Atlantic City filed for a prepack bankruptcy. Debt holders who put up $1.155 billion in February 2011 would own 82 percent of the company’s equity when it emerged from bankruptcy. On May 21, 2013, the company formally emerged from Chapter 11 bankruptcy. As an aside, in 2010, investment bank Morgan Stanley walked away from its entire $932 million investment in the company, so all-in-all, the Revel proved to be an expensive bet.

Prepackaged bankruptcy arrangements require that most creditors reach agree- ment privately. Prepackaged bankruptcy doesn’t seem to work when there are thou- sands of reluctant trade creditors, such as in the case of a retail firm like Macy’s or Revco D. S.12

The main benefit of prepackaged bankruptcy is that it forces holdouts to accept a bankruptcy reorganization. If a large fraction of a firm’s creditors can agree privately to a reorganization plan, the holdout problem may be avoided. It makes a reorganization plan in formal bankruptcy easier to put together.13

A study by McConnell, Lease, and Tashjian reports that prepackaged bankruptcies offer many of the advantages of a formal bankruptcy, but they are also more efficient. Their

12Sris Chatterjee, Upinder S. Dhillon, and Gabriel G. Ramirez, in “Resolution of Financial Distress: Debt Restructurings via Chapter 11, Prepackaged Bankruptcies and Workouts,” Financial Management (Spring 1996), find that firms using prepackaged bankruptcy arrangements are smaller and in better financial shape and have greater short-term liquidity problems than firms using private workouts or Chapter 11. 13During bankruptcy, a proposed plan can be “crammed down” on a class of creditors. A bankruptcy court can force creditors to participate in a reorganization if it can be shown that the plan is “fair and equitable.”

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CHAPTER 30 Financial Distress ■■■ 935

results suggest that the time spent and the direct costs of resolving financial distress are less in a prepackaged bankruptcy than in a formal bankruptcy.14

Predicting Corporate Bankruptcy: The Z-Score Model Many potential lenders use credit scoring models to assess the creditworthiness of pro- spective borrowers. The general idea is to find factors that enable the lenders to discrimi- nate between good and bad credit risks. To put it more precisely, lenders want to identify attributes of the borrower that can be used to predict default or bankruptcy.

Edward Altman, a professor at New York University, has developed a model using financial statement ratios and multiple discriminant analyses to predict bankruptcy for publicly traded manufacturing firms. The resultant model is of the form:

Z = 3.3 EBIT __________ Total assets + 1.2 Net working capital

_________________ Total assets

+ 1.0 Sales __________ Total assets + .6 Market value of equity

____________________ Book value of debt

+ 1.4 Accumulated retained earnings

___________________________ Total assets

where Z is an index of bankruptcy. A score of Z less than 2.675 indicates that a firm has a 95 percent chance of becoming

bankrupt within one year. However, Altman’s results show that in practice scores between 1.81 and 2.99 should be thought of as a gray area. In actual use, bankruptcy would be predicted if Z # 1.81 and nonbankruptcy if Z $ 2.99. Altman shows that bankrupt firms and nonbankrupt firms have very different financial profiles one year before bankruptcy.15 These different financial ratios are the key intuition behind the Z-score model and are depicted in Table 30.2.

30.6

14 John J. McConnell, Ronald Lease, and Elizabeth Tashjian, “Prepacks as a Mechanism for Resolving Financial Distress: The Evidence,” Journal of Applied Corporate Finance 8 (1996). 15 Although these are the original values proposed by Altman, in a more recent interview, he stated that a negative Z-score was now an indicator of potential bankruptcy. http://americasmarkets.usatoday.com/2014/09/18/z-score-predicts-doom-of-6-companies/.

Table 30.2 Financial Statement

Ratios One Year before Bankruptcy:

Manufacturing Firms

Average Ratios One Year before Bankruptcy of :

Bankrupt Firms Nonbankrupt Firms

Net working capital

________________ Total assets −6.1% 41.4%

Accumulated retained earnings

_________________________ Total assets −62.6% 35.5%

EBIT __________ Total assets −31.8% 15.4%

Market value of equity

__________________ Total liabilities 40.1% 247.7%

Sales ______ Assets 150 % 190 %

SOURCE: Edward I. Altman, Corporate Financial Distress and Bankruptcy (New York: John Wiley & Sons, 1993), Table 3.1, p. 109.

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936 ■■■ PART VIII Special Topics

EXAMPLE 30.3 U.S. Composite Corporation is attempting to increase its line of credit with First National State Bank.

The director of credit management of First National State Bank uses the Z-score model to determine creditworthiness. U.S. Composite Corporation is not an actively traded firm and market prices are not always very reliable, so the revised Z-score model can be used.

The balance sheet and income statement of U.S. Composite Corporation are in Tables 2.1 and 2.2 (Chapter 2).

The first step is to determine the value of each of the financial statement variables and apply them in the revised Z-score model:

($ in millions)

Net working capital

________________ Total assets = 275 _____ 1,879 = .146

Accumulated retained earnings

_________________________ Total assets = 390 _____ 1,879 = .208

EBIT __________ Total assets = 219 _____ 1,879 = .117

Book value of equity

_________________ Total liabilities = 805 ____ 588 = 1.369

The next step is to calculate the revised Z-score:

Z 5 6.56 3 .146 1 3.26 3 .208 1 1.05 3 .117 1 6.72 3 1.369

5 10.96

Finally, we determine that the Z-score is above 2.9, and we conclude that U.S. Composite is a good credit risk.

Altman’s original Z-score model requires a firm to have publicly traded equity and be a manufacturer. He uses a revised model to make it applicable for private firms and nonmanufacturers. The resulting model is this:

Z = 6.56 Net working capital _________________ Total assets + 3.26 Accumulated retained earnings

_________________________ Total assets

+ 1.05 EBIT __________ Total assets + 6.72 Book value of equity

__________________ Total liabilities

where Z , 1.23 indicates a bankruptcy prediction, 1.23 # Z # 2.90 indicates a gray area, and Z . 2.90 indicates no bankruptcy.

Summary and Conclusions This chapter examined what happens when firms experience financial distress.

1. Financial distress is a situation where a firm’s operating cash flow is not sufficient to cover contractual obligations. Financially distressed firms are often forced to take corrective action and undergo financial restructuring. Financial restructuring involves exchanging new financial claims for old ones.

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CHAPTER 30 Financial Distress ■■■ 937

2. Financial restructuring can be accomplished with a private workout or formal bankruptcy. Financial restructuring can involve liquidation or reorganization. However, liquidation is not as common.

3. Corporate bankruptcy involves Chapter 7 liquidation or Chapter 11 reorganization. An essential feature of the U.S. bankruptcy code is the absolute priority rule. The absolute priority rule states that senior creditors are paid in full before junior creditors receive anything. However, in practice the absolute priority rule is often violated.

4. A newer form of financial restructuring is prepackaged bankruptcy. It is a hybrid of a private workout and formal bankruptcy.

5. Firms experiencing financial distress can be identified by different-looking financial statements. The Z-score model captures some of these differences.

Concept Questions 1. Financial Distress Define financial distress using the stock-based and flow-based

approaches.

2. Financial Distress What are some benefits of financial distress?

3. Prepackaged Bankruptcy What is prepackaged bankruptcy? What is the main benefit of prepackaged bankruptcy?

4. Financial Distress Why doesn’t financial distress always cause firms to die?

5. Liquidation versus Reorganization What is the difference between liquidation and reorganization?

6. APR What is the absolute priority rule?

7. DIP Loans What are DIP loans? Where do DIP loans fall in the APR?

8. Bankruptcy Ethics Firms sometimes use the threat of a bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such cases the firm is using bankruptcy laws “as a sword rather than a shield.” Is this an ethical tactic?

9. Bankruptcy Ethics Several firms have entered bankruptcy, or threatened to enter bankruptcy, at least in part as a means of reducing labor costs. Whether this move is ethical, or proper, is hotly debated. Is this an ethical use of bankruptcy?

10. Bankruptcy versus Private Workouts Why do so many firms file for legal bankruptcy when private workouts are so much less expensive?

Questions and Problems 1. Chapter 7 When the Beacon Computer Company filed for bankruptcy under Chapter

7 of the U.S. bankruptcy code, it had the following balance sheet information:

Liquidating Value Claims

Trade credit $ 4,700 Secured mortgage notes 7,400 Senior debentures 12,000 Junior debentures 19,000

Total assets $31,400 Equity −11,700

BASIC (Questions 1–2)

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938 ■■■ PART VIII Special Topics

Assuming there are no legal fees associated with the bankruptcy, as a trustee, what distribution of liquidating value do you propose?

2. Chapter 11 When the Master Printing Company filed for bankruptcy, it filed under Chapter 11 of the U.S. bankruptcy code. Key information is shown here:

Assets Claims

Mortgage bonds $20,000 Senior debentures 10,500 Junior debentures 7,500

Going concern value $29,000 Book equity −9,000

As a trustee, what reorganization plan would you accept?

3. Z-Score Fair-to-Midland Manufacturing, Inc. (FMM), has applied for a loan at True Credit Bank. Jon Fulkerson, the credit analyst at the bank, has gathered the following information from the company’s financial statements:

Total assets $95,000 EBIT 7,300 Net working capital 3,800 Book value of equity 21,000 Accumulated retained earnings 19,600 Sales 104,000

The stock price of FMM is $27 per share and there are 7,500 shares outstanding. What is the Z-score for this company?

4. Z-Score Jon Fulkerson has also received a credit application from Seether, LLC, a private company. An abbreviated portion of the financial information provided by the company is shown below:

Total assets $73,000 EBIT 7,900 Net working capital 4,200 Book value of equity 18,000 Accumulated retained earnings 16,000 Total liabilities 64,000

What is the Z-score for this company?

INTERMEDIATE (Questions 3–4)

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