178 CHAPTER 4 Bonds and Their Valuation
Drexel Burnham Lambert to leap from essentially nowhere in the 1970s to become
the most profitable investment banking firm during the 1980s.
The phenomenal growth of the junk bond market was impressive, but controver-
sial. In 1989, Drexel Burnham Lambert was forced into bankruptcy, and “junk bond
king” Michael Milken, who had earned $500 million two years earlier, was sent to jail.
Those events led to the collapse of the junk bond market in the early 1990s. Since
then, however, the junk bond market has rebounded, and junk bonds are here to stay
as an important form of corporate financing.
Bankruptcy and Reorganization
During recessions, bankruptcies normally rise, and recent recessions are no exception.
The 1991–1992 casualties included Pan Am, Carter Hawley Hale Stores, Continental
Airlines, R. H. Macy & Company, Zale Corporation, and McCrory Corporation. The
recession beginning in 2001 has already claimed Kmart and Enron, and there will
likely be more bankruptcies in 2002 if the economy continues to decline. Because of
its importance, a brief discussion of bankruptcy is warranted.
When a business becomes insolvent,it does not have enough cash to meet its inter-
est and principal payments. A decision must then be made whether to dissolve the firm
through liquidationor to permit it to reorganizeand thus stay alive. These issues are ad-
dressed in Chapters 7 and 11 of the federal bankruptcy statutes, and the final decision
is made by a federal bankruptcy court judge.
The decision to force a firm to liquidate versus permit it to reorganize depends on
whether the value of the reorganized firm is likely to be greater than the value of the
firm’s assets if they are sold off piecemeal. In a reorganization, the firm’s creditors ne-
gotiate with management on the terms of a potential reorganization. The reorgani-
zation plan may call for a restructuringof the firm’s debt, in which case the interest
rate may be reduced, the term to maturity lengthened, or some of the debt may be
exchanged for equity. The point of the restructuring is to reduce the financial charges
to a level that the firm’s cash flows can support. Of course, the common stockholders
also have to give up something—they often see their position diluted as a result of ad-
ditional shares being given to debtholders in exchange for accepting a reduced
amount of debt principal and interest. In fact, the original common stockholders of-
ten end up with nothing. A trustee may be appointed by the court to oversee the re-
organization, but generally the existing management is allowed to retain control.
Liquidation occurs if the company is deemed to be too far gone to be saved—if it
is worth more dead than alive. If the bankruptcy court orders a liquidation, assets are
sold off and the cash obtained is distributed as specified in Chapter 7 of the Bank-
ruptcy Act. Here is the priority of claims:
- Secured creditors are entitled to the proceeds from the sale of the specific prop-
erty that was used to support their loans.
- The trustee’s costs of administering and operating the bankrupt firm are next in line.
- Expenses incurred after bankruptcy was filed come next.
- Wages due workers, up to a limit of $2,000 per worker, follow.
- Claims for unpaid contributions to employee benefit plans are next. This amount,
together with wages, cannot exceed $2,000 per worker.
- Unsecured claims for customer deposits up to $900 per customer are sixth in line.
- Federal, state, and local taxes due come next.
- Unfunded pension plan liabilities are next although some limitations exist.
- General unsecured creditors are ninth on the list.
- Preferred stockholders come next, up to the par value of their stock.
- Common stockholders are finally paid, if anything is left, which is rare.
174 Bonds and Their Valuation
