Hartwell Services hit hard times in 2020. They were a placement service business that had $50 million of unsecured debt owed to multiple parties. The debt normally earned 2% interest. Hartwell Services was running out of cash due to the Pandemic. They looked into selling the firm to a larger competitor and they were offered only $35 million for all the firms assets. If sold at that time, cash would go to payoff the debt owed at that time with anything leftover going to shareholders.

Hartwells managers were also large shareholders. They were not too optimistic. To survive they would have to file bankruptcy since the firm had no cash. They also figured that to keep the firm alive for 12 months, they would need $5 million to cover cash operating losses during that time period. To get the $5 million to cover losses, the firm would get a debtor in possession loan approved by a judge. The lender would be Tuscaloosa Bank and 2% interest would be charged on the loan $5 million loan over 1 year. The managers also believed that they would owe $1.5 million in legal and administrative costs unrelated to operations after 12 months.

Once 12 months was up, managers felt if the Pandemic lifted in one year, the firm could be sold for $65m. This amount could be used to payoff creditors and lawyers first and then shareholders with what was left. Managers felt there was a 30% chance of getting this good outcome.

The management believed there was a 70% chance the Pandemic would NOT turn around within 1 year. In that case, they would only be able to liquidate the firm for S15 million and that $15 million would be used to pay off Tuscaloosa Bank (principal and interest) and $1.5 million for the lawyers. What was left would go to the unsecured creditors.

To summarize end outcomes in 12 months

Order of payment in 12 months if bad outcome (70% of time) occurs assuming equity gets nothing

Lawyers ($1.5m) and Bank making DIP loan ($5m x 1.02)

Unsecured Creditors: $15m payments above

Order of payment in 12 months if bad outcome (70% of time)

Lawyers ($1.5m) and Bank making DIP loan ($5m x 1.02)

Unsecured Creditors: $50m x 1.02

Equity gets $65m less payments to Lawyers, bank and unsecured creditors

1. Assume that negotiations with lenders were not feasible or productive. Assuming the managers do what is best for shareholders, would they sell the business in 2020 or file bankruptcy and continue on for 12 months?

2. If they file bankruptcy, what is the equity worth and what is the unsecured debt worth at the time of the bankruptcy filing. Assume investors are risk neutral. This means that they require the same Expected return no matter what the risk. This simplifies things. Assume debt and equity investors require a 2% return

3. if the firm had all equity and no debt, would management have sold the business in 2020 rather than continue to operate for the next 12 months? Briefly explain.

4. Is value lost because the firm borrowed $50m rather than be all equity when the firm was previously financed? Briefly explain.

5. Would any value likely have been lost if the firm borrowed $10m rather than $50m? Briefly explain.

6. If there had been one lender and they were willing to accept less than $50m to settle their debt claim, do you think mangers could have cut a deal with the one lender to avert bankruptcy?