Principles of Finance: Unit 5, The Process of Bankruptcy

The process of bankruptcy is a process we here at Shmoop hope to never personally experience, but we're certainly willing to teach you about.

CoursesFinance Concepts
Principles of Finance
FinanceFinancial Responsibility
Personal Finance
Finance and EconomicsPrinciples of Finance
LanguageEnglish Language
Life SkillsPersonal Finance
SubjectsFinance and Economics

Transcript

00:26

solid tons of room to do small things with their cash and you know move on but

00:31

no the CEO had to be a hero instead and well he turned it into a huro, you know [Person grabs sauce bottle]

00:37

those things in New York and the things that they push up on the street....

00:39

so the company took out a whole bunch of debt bought a

00:44

bunch of competitors and well here's the sorry tail yeah so what is the story [Sauce boiling in a pot]

00:49

here the numbers are telling us well the company took out two billion dollars in

00:53

loans to vastly overpay to buy out competitors and it never locked in its

01:00

interest rate so in the middle year it paid seven and a half percent interest

01:04

on two billion dollars and it eked out 50 million of profits which is just

01:09

dandy but then in the next year without the original management sticking around

01:14

well the acquisition sucked revenues went down dramatically and the company [Revenues of sauce company decline]

01:19

actually lost money big money well problems were exacerbated by the

01:23

fact that the company hadn't locked in interest rates on the two billion

01:27

dollars it owed so when prevailing rates went up another two and a half percent [prevailing rates rises]

01:32

well the company found its new rate to be ten percent on the two billion

01:36

dollars it still owed and with two hundred million dollars in interest

01:40

expenses while the company lost a hundred fifty million dollars which then

01:45

chewed up all of the excess cash it originally had and in the following year

01:50

it would in fact fail to be able to pay even its interest expenses yeah

01:55

bankruptcy so what happens now well in essence the lenders the people who

01:59

loaned him the money own the company as part of a contract they promised when

02:03

they sign the two billion dollar bond paperwork but the lenders don't want to

02:07

own the company lenders like golf and long lunches they don't like having to [People having lunch]

02:12

run you know a sauce company especially one that is dying so the lenders have a

02:17

few choices in reality most of the time banks don't

02:21

take risk that is they "renegotiate the terms of the loan" with the

02:27

company in this case well the bank might add to the principal amount borrowed [Principal amount increased]

02:31

like make it 2.3 billion so that the company has time to shut down

02:35

unprofitable divisions has enough capital to pay the lenders their

02:39

interest and keep operating essentially the bank's loan the company

02:43

an additional three hundred million dollars so that the company can pay back

02:47

the banks the interest next year and keep going and then you know the bank [Man playing golf]

02:51

management can keep working on their putting and short game and hopefully

02:55

retire soon well the lenders are making the bet here that the company can figure

02:59

out a way to survive long enough to pay back the owners debt that it's carrying

03:03

and remember lenders don't care about the equity here they just care about

03:08

getting back to their debt because in this illustration the lenders aren't [Money transfers from sauce bottles to lenders]

03:12

actually taking possession of the company it's still run by the previous

03:16

players although with a new CEO at the helm and things you know continue but [Employees of the sauce company]

03:21

there are other times when banks will actually take possession of a company

03:25

and they have a choice if there are assets to be auctioned off well then

03:28

maybe they call eBay and do that you can imagine in this case the old sauce [Sauce pot listed for sale on eBay]

03:33

company might have been worth a billion dollars to you know Geico Heintz and

03:38

Warren Buffett...Warren's good for his money he's got the cashola to pay day

03:42

one so now at least the two billion dollars have failed debt after selling

03:46

off that division is down to "only" a billion dollars but there is

03:51

still the acquisition which they paid two billion dollars to buy and now [man holding pitta bread]

03:55

worth probably something less than a billion dollars well maybe then the bank

03:59

owners auction it off and collect six hundred fifty million, write off the

04:03

remaining 350 and as bad loans go and it's not so terrible and hopefully they

04:08

live to fight another day and remember they collected some

04:11

interest along the way so it's not like they lost everything although this was

04:14

not good all right well often in addition all of the above

04:17

there are huge tax losses in these situations which are actually highly

04:21

valuable believe it or not so let's say an acquirer has a thirty percent tax [30% tax rate of enquirer on whiteboard]

04:25

rate like it's Microsoft or Google or General Foods they're paying 30 percent

04:30

tax and the acquired piece bolted on unsuccessfully to the sauce

04:34

company had 700 million dollars in accumulated losses well if the acquirer [Sauce company with 700 million dollar losses]

04:39

has say three billion dollars in pre-tax or operating profits in a given year

04:44

well often that 700 million dollars in "phantom" tax losses can be

04:49

used as a direct tax edge specifically that means that on its own the three

04:54

billion dollars of profits would carry a 30 percent tax rate or 900 million

04:57

dollars in taxes paid but the acquired piece would essentially remove 700 [700 million dollar losses highlighted]

05:02

million dollars of those profits so that on a tax basis the highly profitable

05:06

companies 3 billion dollars in profits looks to the IRS in a more like 2.3

05:12

billion dollars in profits that is the 700 million dollars is subtracted from

05:16

the company's profits the profitable successful ones profits and that company

05:20

now pays tax on 2.3 billion of 30% or 690 million instead of that whole

05:25

shabang 3 billion it's not quite that simple in real life but you get the gist

05:30

here the old taxes were 900 million the new ones are now 690 million so the [Old and new taxes]

05:36

"asset" of the tax loss that it acquired in the acquisition ended up

05:41

being worth 200 million dollars in tax savings to the acquirer sounds crazy but

05:46

that's how things work sorta welcome to America [Man holding up small America flag]

05:49

no kneeling but yes you future lawyers out there technically this isn't exactly

05:53

how it works and there are tons of tests that tax loss transfers have to meet

05:58

like it has to be the same basic product in the same basic industry in the same

06:02

basic region and so on but for our purposes the key idea here is that the

06:06

tax loss is actually worth something and yes that's odd but true and that's one

06:11

way you go bankrupt you borrow too much money you can't pay it back and then [Bank transfers money to a person]

06:15

well the banks end up owning whatever it is you're sauce company or towel

06:18

distribution company or whatever it is you do and if you really want the nitty

06:22

and the gritty we have videos on chapter 7 versus chapter 11 style bankruptcy

06:26

whole bunch of flavors of the B word you just know you want to avoid it [Selection of ice cream flavors]