Is It Worth More Dead or Alive?

Alex Peterson, president of Peterson Investments Inc., was faced with a major decision. One of
the firms that his company had invested in, Durawear Corporation, was under severe financial
distress. It had therefore sent out a proposal for reorganization, which if approved by a majority
of the creditors would lead to a “pre–pack” in the hope that the company could restructure itself
and be salvaged. Being rather unfamiliar with the various regulations and nuances associated
with corporate bankruptcy, Alex summoned his chief financial officer, Don Thompson. “I am
really stumped on this one, Don,” said Alex, pointing to the proposal lying on his desk. “First
bankruptcy case that I have encountered in my fifteen years of investing. I’d like you to take a
look at the numbers and the proposal and make a recommendation whether I should vote for or
against the reorganization plan!” The Durawear Corporation, incorporated in 1985, designed,
manufactured, imported, and marketed various menswear, children’s sleepwear and underwear,
and other apparel products. It sold its products to department and specialty stores, national chains,
major discounters, and mass-volume retailers throughout the United States. About nine years
earlier, when sales were booming, the company undertook a major business expansion, almost
doubling its manufacturing capacity. The expansion was primarily financed by the issuance of
senior notes and preferred stock. However, due to significantly lower profit margins and
declining demand caused by increasing competition and weak economic conditions, the company
faced negative earnings and poor liquidity conditions during the past three years. Initial attempts
to cut costs did alleviate the problems a bit, but with debt servicing costs being fairly high, the
company’s cash flows declined sharply. With the senior notes coming up for redemption within a
year, the company’s management was concerned that they would not be able to refinance the
debt nor have the liquidity to pay off the creditors in time. They had therefore embarked upon a
voluntary reorganization plan by which the debt would be exchanged for common stock, if
agreed upon by the majority of creditors. Table 1 shows the latest balance sheet of the company.
Peterson had purchased $5 million worth of Durawear Corporation’s senior notes about nine
years ago. The industry outlook was good, and the 10.5% yield on the 10-year notes certainly
looked enticing. The company had demonstrated a good record of complying with its interest and
dividend obligations, and analysts were bullish on the performance of its common stock.

In their letter to the creditors, Durawear Corporation’s management had explained that the
current situation was, in their opinion, temporary, and that if given a chance to reorganize and
restructure, they would do their best to steer the company back onto the road to profitability. It
was their intention to arrive at an agreement with the majority of creditors and then go for a
prepackaged bankruptcy. The reorganization plan called for the exchange of 90.5805 shares of
new common stock for each $1,000 face value of the senior debt. The management pointed out
that if the firm was forced to liquidate, its current assets could probably be sold for about 40% of
book value and its fixed assets would bring in about $9 million. However, roughly 20% of the
gross proceeds would have to be paid towards administrative fees and other charges. After
reading the letter and going over the financial statements of Durawear, Alex Peterson was clearly
undecided. On the one hand, it seemed as if the management team was serious and confident
about being able to weather this storm and make the company profitable once again. On the other
hand, Alex was concerned that the problems could get worse and he could end up with nothing.
He was hoping that his CFO would shed some light on this matter and help him decide whether
Durawear was worth more dead or alive.
Table 1 - Durawear Corporation Latest Fiscal Year Balance Sheet (‘000s)

Current Assets $140,000 Accounts Payable

Notes Payables
Net Fixed Assets 20,000 Accrued Wages
Federal Taxes Due
State & Local Taxes Due
Current Liabilities
First Mortgage
Second Mortgage
10.5% Senior Notes
Long-Term Debt
Preferred Stock
Common Stock
Paid in Capital
Retained Earnings
Total Equity
Total Assets 160,000 Total Liabilities and Owners’ Equity

Questions: PLEASE ANSWER ALL OF THE FOLLOWING QUESTION CORRECTLY!!

I NEED HELP ON ALL OF THEM!!

1.What are the various ways in which firms can be financially distressed? What seems to be the
main problem at Durawear Corporation?

2.What does the “absolute priority rule” mean? Develop a priority list for Durawear that would
be followed if it were liquidated.

3.Why has Durawear’s management attempted to get a prepackaged bankruptcy?

4.Define the following terms within the context of this case:

a. Workout

b. Reschedule/restructure

c. Extension

d. Composition

e. “Cram down”
f. Automatic stay

5.How does insolvency differ from bankruptcy? Which one applies to Durawear, and why?

6.If you were Don Thompson, how would you explain the differences between bankruptcy
reorganization and bankruptcy liquidation to Alex Peterson?

7.Should Alex vote in favor of or against the voluntary reorganization? Explain why by
performing the necessary calculations.