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“The payment of debts is necessary for social order. The non-payment is quite equally necessary for social order. For centuries humanity has oscillated, serenely unaware, between these two contradictory necessities.”—Simone Weil

UAL—What’s important

 How bankruptcy process (Chapter 11) works – Automatic Stay, DIP financing, Reorg plan  Why we have Chapter 11 – Debtor-friendly nation going back to founding  Costs of financial distress are real – In bankruptcy and before bankruptcy – Rooted in human imperfections » Bounded knowledge » Self-interested deceit  Trade-off theory of capital structure © Carliss Y. Baldwin, 2010

Priority of claims in Chapter 11

      Secured Super-priority (DIP) Priority – Admin – Wages, salaries, commissions – Employee benefits – Facilities storing grain or fish – Consumer deposits – Alimony and child support – Taxes – Claims of FDIC-insured institutions Other unsecured Preferred stock Common Stock UAL settlement 100% 100% 100% 4-8% 0% 0%

Power of Bankruptcy Code

• • • • • Automatic stay – Prevents parties from seizing assets right away – Does not apply to broker-dealers (a critical fact in Lehman bankruptcy) Lifeline of DIP financing (super-senior lines of credit) Funnels disparate groups into one forum – Unions, aircraft financiers, gov’t agencies like PBGC Imposes deadlines on key parties – Benefit of immediacy Provides framework/support for negotiations © Carliss Y. Baldwin, 2010

US is a “debtor-friendly” nation Restructuring Laws Vary by Country

    France – Court appointed official helps managers generate a reorganization plan. Creditors have one representative for all classes.

U.K.

– Administration - accountant or lawyer runs the firm. Administrative receivership - secured creditors run the firm. Generally, assets liquidated Japan – Informal rescues more common than formal bankruptcies, but this may be changing.

Sweden – Court-appointed official auctions the firm.

Optimal/Target capital structure—Checklist         Can company pay interest—coverage ratios?

– EBIT/Int, EBITDA/Int – In good times and bad Industry volatility or cyclicality?

– Operating leverage makes cash flow more volatile/cyclical Industry standards—what are competitors doing?

Is company able to make use of its ITS?

Costs of financial distress?

– What will customers and suppliers do in shadow of bankruptcy?

Agency costs?

– High leverage=>Mgrs take negative NPV projects with high risk – Low leverage=>Mgrs have few incentives to be efficient, may consume excess perks (private jets, plush offices…) Leverage needed to control renk-seeking?

– Unions and/or regulators Does company need strategic flexibility?

– Will covenants interfere with strategy?

Getting to your optimal capital structure

Stone’s V = D+E = 4323 +1189 = 5512         From low leverage, it’s easy: do a leveraged recap From high leverage,

it’s hard

Assume D+E is approx constant (Ignore value of ITS) Each 1% decline in D/V => $55MM in new equity To go from 78% to 50% requires ~ $1.5 B in new equity!

At least 100 MM new shares (1.5 B/$15) Dilution = 100/(100+71) = 58% Family share = 42% of what it was before the issue © Carliss Y. Baldwin, 2010

And that’s before announcement effects!

     Two explanations for the drop in Pstk on announcement of equity issue Debt overhang – Transfer of value from new equity to impaired debt – Arises under

symmetric

information when

D/V is high

Signaling – Action (debt or equity) communicates true state of company to market – Arises under

asymmetric