Question

Subject : Corporate Finance Theory

Please provide me answers with details that is based on the corporate finance theories

Answer the following two questions:

1. With debtor in possession (DIP) financing, the bankrupt firm can obtain additional amounts of debt senior to the firm’s existing debt. Explain how the firm’s existing debtholders can benefit from this.
2. Would debtholder-equityholder conflicts be more severe for firms that borrow short term than long term? Explain why.

Answer 1

Debtor in Possession (DIP)

A debtor in possession (DIP) is a person or corporation that has filed for Chapter 11 bankruptcy protection, but still holds property to which creditors have a legal claim under a lien or other security interest. A DIP may continue to do business using those assets, but is required to seek court approval for any actions that fall outside of the scope of regular business activities. The DIP must also keep precise financial records, insure any property, and file appropriate tax returns.

Rights as a Debtor in Possession (DIP)

The key advantage to DIP status is, of course, to be able to continue running a business, albeit with the power and obligation to do so in the best interest of any creditors. After filing for Chapter 11 bankruptcy, the debtor must close the bank accounts they used prior to the filing and open new ones that name the DIP and their status on the account.

From that point on, a number of decisions the debtor might previously have made alone must now be approved by a court. Provided they obtain that permission, however, a DIP may be able to secure debtor-in-possession financing (DIP financing) that can help to keep the business solvent until it can be sold.

A debtor in possession can sometimes even retain property by paying the creditor fair market value for it, again if the court approves the sale. For example, a debtor may seek to buy back their personal car (a depreciated asset) so they can use it to work or find work to pay off the creditor.

Obligations as a Debtor in Possession (DIP)

A debtor in possession must not only act in the best interests of creditors, but also of employees of the business. Wages must be paid and withholdings made, with the withheld funds used to deposit taxes and pay both the employee and employer share of FICA.

Other spending is closely regulated. For example, the debtor cannot pay off any debts that arose prior to filing for bankruptcy unless those are permissible under the Bankruptcy Code or have been approved by the court. Nor can the DIP put up company assets as collateral or employ and pay professionals without the same permission.

Similarly, unless the court rules otherwise, federal, state, and local tax returns must continue to be filed when due, or with extensions sought by the DIP as needed. The DIP also needs to maintain adequate insurance on estate assets—and to be able to document that coverage—and must provide periodic reporting on the financial health of the business.

Should the debtor not meet these obligations, or fail to follow court orders, the DIP designation can be terminated, after which the court will appoint a trustee to manage the business. That step can make it more difficult for the debtor to salvage its enterprise and deal with its debts.

Debtor in possession (DIP) financing

Debtor-in-possession (DIP) financing is a special kind of financing meant for companies that are in bankruptcy. Only companies that have filed for bankruptcy protection under Chapter 11 are allowed to access DIP financing, which usually happens at the start of a filing. DIP financing is used to facilitate the reorganization of a debtor-in-possession (the status of a company that has filed for bankruptcy) by allowing it to raise capital to fund its operations as its bankruptcy case runs its course. DIP financing is unique from other financing methods in that it usually has priority over existing debt, equity, and other claims.

Since Chapter 11 favors corporate reorganization over liquidation, filing for protection can offer a vital lifeline to distressed companies in need of financing. In debtor-in-possession (DIP) financing, the court must approve the financing plan consistent with the protection granted to the business. Oversight of the loan by the lender is also subject to the court's approval and protection. If the financing is approved, the business will have the liquidity it needs to keep operating.

When a company is able to secure DIP financing, it lets vendors, suppliers, and customers know that the debtor will be able to remain in business, provide services, and make payments for goods and services during its reorganization. If the lender has found that the company is worthy of credit after examining its finances, it stands to reason that the marketplace will come to the same conclusion.

As part of the Great Recession, two bankrupt U.S. automakers, General Motors and Chrysler, were the beneficiaries of debtor-in-possession (DIP) financing.

Obtaining Debtor-in-Possession (DIP) Financing

DIP financing usually occurs at the beginning of the bankruptcy filing process, but often, struggling companies that may benefit from court protection will delay filing out of failure to accept the reality of their situation. Such indecision and delay can waste precious time, as the DIP financing process tends to be lengthy.

Seniority

Once a company enters into Chapter 11 bankruptcy and finds a willing lender, it must obtain approval from bankruptcy court. Providing a loan under bankruptcy law provides a lender with much-needed comfort in providing financing to a company in financial distress. DIP financing lenders are given first priority on assets in case of the company's liquidation, an authorized budget, a market or premium interest rate, and any additional comfort measures that the court or lender believes warrants inclusion. Current lenders usually have to agree to the terms, particularly in taking a back seat to a lien on assets.

Authorized Budget

The approved budget is an important aspect of DIP financing. The "DIP budget" can include a forecast of the company's receipts, expenses, net cash flow, and outflows for rolling periods. It must also factor in forecasting the timing of payments to vendors, professional fees, seasonal variations in its receipts, and any capital outlays. Once the DIP budget is agreed upon, both parties will agree on the size and structure of the credit facility or loan. This is just a part of the negotiations and legwork necessary to secure DIP financing.

Types of Loans

DIP financing is frequently provided via term loans. Such loans are fully funded throughout the bankruptcy process, which means higher interest costs for the borrower. Formerly, revolving credit facilities were the most utilized method, which allows a borrower to draw down the loan and repay as needed; like a credit card. This allows for more flexibility and therefore the ability to keep interest costs lower, as a borrower can actively manage the amount of the loan borrowed.