Measures would help UAL Corporation to get out of bankruptcy

UAL Bankruptcy 2004 

UAL Corporation, formerly known as United Continental Holdings, is an airline that was founded in 1968 in Chicago, Illinois. The main aim of the airline was to offer affordable carrier services for passengers and cargo. When formed, UAL Corporation held 100% non-controlling interest (NCI) in United Airlines, thus making it the largest air carrier in the world. In 2010, the management of UAL Corporation announced that Continental Airlines and UAL Corporation would merge. During that year, the management of UAL Corporation had decided that they would purchase Continental Airlines and alter their name to United Continental Holdings to show the merger. In October 2010 whereby the merger was completed, and in June 2019, the company’s name was later changed to United Airlines Holdings. United Airlines Holdings is situated in the transport sector, specifically the airlines' industry. 

In 2004, UAL Corporation into bankruptcy which became tough for its operations. Since 2002 when Glenn Tilton was appointed as the chairman, president and chief executive officer (CEO) of UAL Corporation, he faced tough decisions since the corporation had been operating under bankruptcy protection and in July 2004, UAL Corporation was declared bankrupt for more than one year and seven months. During 2004, Glenn was required to submit a restructuring proposal to the creditors of the company. Due to the intense competition that UAL Corporation faced in the industry, their pension fund became underfunded by more than $7.5 billion even though UAL Corporation was required to contribute $72M to the pension in July and more than $500M by the end of the fiscal year as per the new rules set by ERISA and IRS. Proper measures would help UAL Corporation to get out of bankruptcy and thus immediately return into profitability. 

Financial Analysis 

Financial Bankruptcy of UAL Corporation 

Financial distress is the chance of voluntary exit of an organization from the sector as a result of failure to operate within the industry standards. Financial distress is expected to increase depending on the debt or cash level of the firm (Keasey, Pindado, and Rodrigues, 2015). Thus, the organization would fail to honor its financial obligations when they become due. On the other hand, when a firm has a lower debt level when compared to the level of cash that it holds, it would be said to be performing well, and thus its chances of going into financial distress would be minimal. Taliani (2010) suggests that financial distress or bankruptcy shows a situation when an organization is unable fulfill its promises to its creditors. Hence, using models to predict financial distress can help a company to know whether it is going into bankruptcy or not. 

A number of reasons made UAL to go into bankruptcy in 2004. Firstly, since 2002, UAL was operating under bankruptcy protection, and this meant the management had to involve a lot of economists, lawyers, and bankers with their fees totaling to $10 million every month (UAL, 2006). The fees to be paid to the economists, lawyers and bankers posed financial challenges for UAL, and in 2004, the company could no longer take it, thus going into bankruptcy. 

Secondly, during that same year, the prices of oil were skyrocketing, and this was hurting the bottom line of UAL Corporation (UAL, 2006). Before the bankruptcy, UAL had hedged itself against exposure to fluctuating oil prices through derivatives. However, the bankruptcy protection affected the ability of the corporation to make the required payments through the SWAP contracts derivative. UAL faced cash constraints and this forced it to terminate the majority of its commitments, thus being exposed to potential increases in the prices of fuel. 

Finally, UAL Corporation wanted to liquidate most of its fleet to avoid bankruptcy (UAL, 2006). However, according to research, distressed sellers lack flexibility in waiting for better offers, and thus it was sold that was 50% than when it was undistressed (UAL, 2006). As a result, this reduced the value of UAL Corporation, and with the minimal cash that they had, they could not survive the financial distress and thus, UAL had to be liquidated. 

High Debt in the Airlines Industry and whether it is A Consequence of Unionization, its Impact on UAL and How Effective UAL came out of Bankruptcy 

Debt in the airlines sector has been deemed to be relatively high when compared to other sectors due to several reasons (Maverick, 2015). Firstly, for large companies, it is easy to acquire debt when compared to smaller ones. The airlines sector, therefore, takes advantage of this fact which makes them acquire more and more debt. Secondly, the airlines industry acquires more leverage when compared to other sectors to attain economies of scale. Ideally, these are the benefits that a business realizes due to operating in a large scale production such as low distribution costs and costs of production. When companies in the airlines industry operate on a large scale, this would make them to have a higher market share when compared to their rivals. Companies in the airlines industry, therefore, acquires leverage to increase their market share. Finally, fluctuation in fuel prices, oil prices, and other market conditions push corporations in the airlines' sector to acquire more leverage to survive. 

Unionization in the airlines industry has been rampant in the past few years. There have been many strikes in the airlines industry, specifically in UAL, as workers demand more pay (Josephs & Wayland, 2019). To continue business operations, a company such as UAL could acquire high leverage to pay its workers and thus prevent them from going into a strike. The trade union may come in to defend their rights and thus advocate for higher pay for them. Therefore, high leverage may be a consequence of unionization in the sector. 

Firstly, UAL’s relationship with its partners was jeopardized after being affected by the bankruptcy (UAL, 2006). Ideally, UAL had been in partnership with Atlantic Coast Airlines. As UAL entered into bankruptcy, the management of Atlantic Coast Airlines became skeptical concerning the future of UAL, and thus they terminated their relationship. Secondly, UAL had to end its pension plans after the occurrence of bankruptcy, which resulted in a lot of consequences (UAL, 2006). 

In 2006, the administration of UAL put themselves in a situation where they were able to compete with the effect of high prices of oil. UAL competed with the impact of high oil prices by focusing on making decisions immediately concerning the bankruptcy which would have an impact on their operations (UAL, 2006). With the low cost advantage that UAL held, the pension plans of the company had to be ended. Despite this, the management of UAL Corporation had to hold negotiations with trade unions and even after agreeing to reducing the wages to be given to the employees, the trade unions were reluctant to discuss the plans for pension of the employees. UAL has been effective in coming out of bankruptcy since they returned to profitability and position themselves to be able to compete with the effects of high prices of oil in 2006. 

Benefits of a Private Workout when Compared to a Formal Bankruptcy and Reasons Why it was not Feasible for UAL 

A private workout is a repayment plan which requires the acceptance of all the creditors (Azmi, Razak & Ahmad, 2017). In contrast, Azmi, Razak and Ahmad (2017) suggest that formal bankruptcy is a repayment plan which involves the approval of only one-half of the creditors owning two-thirds of the outstanding claims. A private workout results in several potential advantages when compared to formal bankruptcy. One possible benefit is that the costs associated with a private workout are generally lower when compared to a formal bankruptcy since the company is allowed to negotiate for lower costs. 

For UAL, the private workout could not be a feasible solution since the creditors knew that if they forgo a part of their original claim, it is likely that they would lose their money since the ultimate payoff would be lower than if the corporation were to be dragged through the bankruptcy courts. Furthermore, the private workout could not have been a feasible solution for UAL since the company owed a lot of creditors. Thus all the creditors owed by the organization would have a high repayment plan for UAL Corporation. 

The Distinction between Liquidation and Reorganization Using the United States Bankruptcy Code and which Process UAL Incorporated 

In the reorganization, a debtor is said to retain ownership of their assets and continue their business operations while negotiating for the debt repayments with the creditors (11 U.S.C. § 1101). For instance, UAL would retain ownership of all its fleets and continue operating as if it was not in bankruptcy when negotiating for the repayment plans with the creditors. In liquidation, on the other hand, the creditors would seize control of the assets of the debtor until when the debtor pays off their debt (11 U.S.C. § 1141(d) (5)). Ideally, this means that the creditors of UAL Corporation would control the assets until when UAL repays their obligations. 

The process used by UAL was part of the liquidation. In June 2004, the federal government of the United States rejected the request of UAL for loan guarantees suggesting that the reorganization plan of the management is unworkable, as seen in Exhibit 3. Ideally, if UAL were to emerge from the bankruptcy, the management would need to develop a plan which their creditors would be willing to accept. Since all the creditors could not allow UAL Corporation to retain ownership of its fleet while the negotiations were happening, a liquidation process was incorporated whereby the creditors controlled the assets of UAL. Therefore, the management had to liquidate some of its fleets of aircraft despite facing challenges in doing so. 

The Absolute Priority Rule and whether it was Followed by the Management of UAL 

The absolute priority rule is a rule which insists that the claims of the creditors have to have an absolute priority over the demands of the shareholders. During the liquidation of the assets of a business, the management would incorporate the absolute priority rule whereby the investors are compensated only after the claims of the auditors have been settled to the satisfaction of the bankruptcy court order. From the case study, it is evident that UAL followed the absolute priority rule since the case study suggests that after liquidation, the remaining assets would be sold by the trustees and the proceeds shared to all the creditors that had claims with the corporation according to the rules of priority of the Bankruptcy code. 

DIP Financing and the Reason for Incorporating it 

Debtor-in-Possession financing, popularly known as DIP, is usually a particular type of funding, which is geared for the organizations that seem to be in financial distress such as UAL Corporation. Ideally, a bankruptcy protection would have to be filled for a firm to be granted the DIP financing. Additionally, it is usually used to when a company is engaging in a reorganization as a result of bankruptcy by allowing the management to raise equity to fund their day-to-day business activity while the bankruptcy case runs. A company would allow such type of financing when it is aware that it would be able to get the required capital before the end of the bankruptcy case. 

The Theory of Modigliani-Miller and Capital Structure 

This is a theory that has been used to understand the capital structure of companies. The Modigliani and Miller theory is an approach that was devised in the 1950s, which advocated for capital structure irrelevance theory. Specifically, the theory suggests that the valuation of an organization is irrelevant to its capital structure such that the value of an enterprise would not be based on its capital structure. Whether a corporation has a high or lower debt level does not determine its value in the market. Additionally, the theory suggested that the market value of an organization is usually influenced by its earnings before interest and taxes (EBIT) as well as the risk involved. Besides, the value of an enterprise does not depend on the financing decision that it makes. 

The J Curve Effect and its Influence in Financial Distress 

The J-curve effect is often used in economics to describe a situation when a dramatic increase or gain immediately follows an initial loss. In terms of bankruptcy, the J-curve effect would occur when a company is in financial distress, and it quickly regains and starts performing well. 

The Theory of Trade-off and its Representation Graphically 

This is a theory of capital structure which tries to achieve a balance between the cost of financial distress and the tax shield benefit of the corporation from using debt. Ideally, an optimal capital structure would exist in this theory when there is a combination of Shareholders’ Equity and debt. The static trade-off theory would be represented graphically, as shown below. 

Whether Equity would be an Option for A Corporation in Distress and the Type of Projects the Equity Owners and Investors in Debt of a Firm Want to Pursue Reject Respectively 

Equity would be an option for a firm that is financial distress to help it get out of bankruptcy. Ideally, an organization can be offered a DIP financing, whereby it is allowed to raise capital when the bankruptcy case is running. Equity owners would engage in projects which provide them with higher returns, and they are assured that the company would attain more significant economic benefits in the future. Debt investors, on the other hand, would reject those projects in which they are convinced that they are not viable, and thus they would lead to loss of the principal and interest amounts. 

The Z-Score Model to Predict the Financial Distress for UAL Corporation and Other Tools in the Prediction of bankruptcy 

The z-score is a model that is used to predict financial distress. Consider the computation shown below for the z-score of UAL Corporation. 

Where; X1 is the ratio of the net working capital of a business to its total assets (Working Capital/ Total Assets) 

X2 is the ratio of the retained earnings of the organization to its total assets (Retained Earnings/ Total Assets) 

X3 is the ratio of the earnings between interest and taxes (EBIT) of a company to its total assets (EBIT/ Total Assets) 

X4 is the ratio of the market value of Equity of the business to its total book value of liabilities (Market Value of Equity/ Total Liabilities) 

X5 is the ratio of sales of a corporation to its total assets (Sales/ Total Assets) 

Z score
X1	Working capital	($612)
	Total Assets	$23,656
			-0.03
X2	Retained earnings	-3,417
	Total assets	$23,656
			-0.14
X3	EBIT	-2,837
	Total assets	$23,656
			-0.12
X4	The market value of Equity	936
	Total liabilities	$26,137
			0.04
X5	Sales	$14,286
	Total assets	$23,656
			0.60
Z-score			0.35

From the table shown above, UAL Corporation has a z-score of 0.35. Ideally, the ideal rule is that if the z-score is more significant than 2.99, then the organization is performing well. Thus its probabilities of going into financial distress are minimal (Stepanyan, 2014). When the z-score is between 1.81 and 2.99, one would be unsure of whether the company has financial distress or not (Stepanyan, 2014). Finally, when the z-score is below 1.81, the company would be said to be in distress (Stepanyan, 2014). In the computation shown above, UAL Corporation would be said to be in financial distress by Dec 2002 since its z-score was lower than 1.81. Other tools that can be used to predict the financial bankruptcy of a company include financial ratios, the multiple discriminant analysis, the KMV approach and so forth. 

Sensitivity Scenario Analysis 

A sensitivity scenario analysis examines the effect of changing all the input variables (Stepanyan, 2014). Considering an increase in 10% of the input variables, below is the sensitivity analysis for the z-score of UAL in December 2002. 

Increase by 10%
Z score
X1	Working capital	($673)
	Total Assets	$26,022
			-0.03
X2	Retained earnings	-3,759
	Total assets	$26,022
			-0.14
X3	EBIT	-3,121
	Total assets	$26,022
			-0.12
X4	The market value of Equity	$1,029.60
	Total liabilities	$28,751
			0.04
X5	Sales	$15,715
	Total assets	$26,022
			0.60
Z-score			0.35

Assuming that the risk decreases by 10% such that the input variables are expected to reduce by 10%. Below is the z-score for UAL Corporation for December 2002. 

Decrease by 10%
Z score
X1	Working capital	($551)
	Total Assets	$21,290
			-0.03
X2	Retained earnings	-3,075
	Total assets	$21,290
			-0.14
X3	EBIT	-2,553
	Total assets	$21,290
			-0.12
X4	The market value of Equity	$842.40
	Total liabilities	$23,523
			0.04
X5	Sales	$12,857
	Total assets	$21,290
			0.60
Z-score			0.35

In both scenarios, it is evident that the z-score for UAL remains the same, and the company would be said to be undergoing financial distress in December 2002. 

Current Updates on the Case 

UAL engaged in a move to terminate its pension plan. After the implementation of the repayment plan that was favorable to the creditors, the pensioners of UAL would lose an amount of between $1.2 billion and $1.9 billion, and the pension assets and liabilities of UAL would be inherited by PBGC to shoulder the underfunded liability of UAL which was between $7.6 billion and $8.3 billion. In 2004, after UAL was declared bankrupt, the management had three options; to make contributions as required by the bankruptcy law, to refrain from making any negotiations and contributions from its employees, and to terminate its pension plans immediately. However, a conclusion by the management to end its plans for pension would have significant impact for UAL Corporation. 

Conclusion 

UAL is a company that got into financial distress in 2002, and by 2004, it was declared bankrupt. From the z-score computation, a z-score of less than 1.81 was achieved for UAL Corporation, which revealed that the company was in financial distress in December 2002. After the implementation of various measures, UAL was able to come out of bankruptcy and thus immediately regain its profitability. In 2006, the management of UAL Corporation decided to position itself to compete with the influence of high oil prices. Hence, this proved to be the return of UAL to profitability and out of financial distress or bankruptcy. 

References 

Azmi, R., Razak, A. A., & Ahmad, S. N. S. (2017, November). Debts Repayment Scheme and Debts Repayment Plan in Singapore and Malaysia: A Legal Overview. In    International Research Symposium Series (IRSS)   (p. 61). 

Josephs, L., & Wayland, M. (2019). Transportation: Corporate Profits Have Soared, and Workers from Amazon to United Airlines are now demanding their Cut. CNBC. Retrieved from https://www.cnbc.com/2019/08/04/workers-from-amazon-to-united-airlines-demand-more-pay-after-profits-soared.html 

Keasey, K., Pindado, J., & Rodrigues, L. (2015). The determinants of the costs of financial distress in SMEs. International Small Business Journal , 33 (8), 862-881. 

Maverick, J. B. (2015). Why do Debt-to-Equity Ratios vary from Industry to Industry? Investopedia. Retrieved from https://www.investopedia.com/articles/investing/083115/why-do-debt-equity-ratios-vary-industry-industry.asp 

Stepanyan, A. (2014). Altman’s Z-Score in the Airline Business. Case study of Major US Carriers. Are they Potential Bankruptcy Candidates? International Journal of Advances in Management and Economics, 3(1), 16-24. 

Taliani, I. J. (2010). Predicting financial distress in commercial banks in Kenya. Unpublished MBA project. University of Nairobi , 2222-1905. 

UAL (2006). UAL 2004: Pulling Out of Bankruptcy. Harvard Business School, 9-205-090.