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Unformatted text preview: onable period, the CHAPTER 17 bankruptcy
Business failure that occurs
when the stated value of a firm’s
liabilities exceeds the fair
market value of its assets. Mergers, LBOs, Divestitures, and Business Failure 735 company may be able to escape complete failure. If not, the result is the third and
most serious type of failure, bankruptcy.
Bankruptcy occurs when the stated value of a firm’s liabilities exceeds the fair
market value of its assets. A bankrupt firm has a negative stockholders’ equity.9
This means that the claims of creditors cannot be satisfied unless the firm’s assets
can be liquidated for more than their book value. Although bankruptcy is an obvious form of failure, the courts treat technical insolvency and bankruptcy in the
same way. They are both considered to indicate the financial failure of the firm. Major Causes of Business Failure
The primary cause of business failure is mismanagement, which accounts for
more than 50 percent of all cases. Numerous specific managerial faults can
cause the firm to fail. Overexpansion, poor financial actions, an ineffective
sales force, and high production costs can all singly or in combination cause
failure. For example, poor financial actions include bad capital budgeting decisions (based on unrealistic sales and cost forecasts, failure to identify all relevant cash flows, or failure to assess risk properly), poor financial evaluation of
the firm’s strategic plans prior to making financial commitments, inadequate
or nonexistent cash flow planning, and failure to control receivables and inventories. Because all major corporate decisions are eventually measured in terms
of dollars, the financial manager may play a key role in avoiding or causing a
business failure. It is his or her duty to monitor the firm’s financial pulse. For
example, the largest bankruptcy ever, Enron Corporation’s early 2002 bankruptcy, was largely attributed to questionable partnerships set up by Enron’s
CFO, Andrew Fastow. Those partnerships were intended to hide Enron’s debt,
inflate its profits, and enrich its top management. In late 2001, these transactions blew up, causing the corporation to file bankruptcy and resulting in criminal charges against Enron’s key executives as well as its auditor, Arthur
Andersen, who failed to accurately disclose Enron’s financial condition.
Economic activity—especially economic downturns—can contribute to the
failure of a firm.10 If the economy goes into a recession, sales may decrease
abruptly, leaving the firm with high fixed costs and insufficient revenues to cover
them. Rapid rises in interest rates just prior to a recession can further contribute
to cash flow problems and make it more difficult for the firm to obtain and maintain needed financing.
A final cause of business failure is corporate maturity. Firms, like individuals,
do not have infinite lives. Like a product, a firm goes through the stages of birth,
growth, maturity, and eventual decline. The...
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