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Principles of finance a la shmoop... the process of bankruptcy

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so what happens when a company goes bankrupt well let's bring back our

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little infamous sauce company and jiggle the numbers the company was doing just [People celebrating company opening]

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fine unleveraged that is it had no debt a hundred million dollars in cash on the

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books and was growing at about 10 percent a year not awesome but good

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

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

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

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

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

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

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

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

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

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

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

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actually lost money big money well problems were exacerbated by the

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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unprofitable divisions has enough capital to pay the lenders their

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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live to fight another day and remember they collected some

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

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

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

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

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

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tax and the acquired piece bolted on unsuccessfully to the sauce

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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