In Re Pullman Construction Industries Inc.

FINDINGS OF FACT AND CONCLUSIONS OF LAW

In connection with the Consolidated Hearing on Confirmation of Debtors’ Fourth Amended Plan As Modified (“Plan”), and Wells Fargo’s Motion to Lift Automatic Stay, the parties having rested, the Court has considered all the admitted evidence and arguments of counsel and all objections and pleadings filed with respect thereto, and now makes and enters the following Findings of Fact and Conclusions *912 of Law. 1 Pursuant thereto, confirmation will be denied and stay modification and other relief ordered.

FINDINGS OF FACT

1. On May 1, 1987 (“Petition Date”), Pullman Construction Industries, Inc., Pullman Sheet Metal Works, Inc., Preferred Piping, Inc., and Mid-City Architectural Iron Co. (collectively referred to as “Debtors” or “Pullman”) filed petitions for relief under Chapter 11 of the Bankruptcy Code, 11 U.S.C. § 101 et seq. Their cases have been jointly administered. No Trustee has been appointed. The Debtors have been administering their affairs as Debtors-in-Possession. The trial on which these Findings are founded came to be heard on the confirmation hearing held on the Debtors’ proposed Plan under 11 U.S.C. §§ 1128, 1129, and Bankruptcy Rules 3020(b) and 9014; and on the final hearing on Wells Fargo’s Motion to Lift Automatic Stay under 11 U.S.C. § 362.

2. Debtors are incorporated under the laws of Illinois, and have their principal place of business in Chicago, Illinois. Pullman Construction Industries, Inc. (“PCI”) is the parent Corporation of three wholly-owned subsidiaries: Pullman Sheet Metal Works, Inc. (“Pullman Sheet Metal”), Preferred Piping, Inc. (“Preferred Piping”), and Mid-City Architectural Iron Co. (“Mid-City”). [Pullman Ex. 2, p. 4.]

3. The stock of Pullman Construction Industries, Inc. (“PCI”) is owned by Lester and Norma Goldwyn. PCI owns all the stock of the other Debtors (collectively the “Stock”). [W.F. Ex. 38.]

4. (a) The primary business of the Debtors is sheet metal and mechanical contracting. [W.F. Ex. 38.]

(b)Pullman employs approximately 125 people and is primarily engaged in the business of heating, ventilating and air-conditioning (“HVAC”) contracting for commercial, industrial and governmental entities. In addition, Pullman designs and manufactures a patented fire damper and related products for the nuclear power industry. [Pullman Ex. 2, p. 1.]

(c) Pullman was founded in 1943 as a sheet metal fabricating company. During the post-war construction boom, Pullman expanded its business to encompass the fabrication and installation of warm air heating, ventilating and air-conditioning (“HVAC”) systems in residential and light commercial buildings. During the 1960’s Pullman continued to expand its business into commercial high-rise construction projects. In the mid-1970’s, after a brief period as a subsidiary of Brand Insulation, Inc., Pullman began providing HVAC contracting services to the nuclear power industry. [Pullman Ex. 2, pp. 5-7.]

(d) Pullman also expanded its business horizontally through the acquisition of Preferred Piping, a plumbing contractor; Mid-City, a manufacturer of gallery work such as gratings, stairs and handrails, principally for nuclear power plants; PCI Engineers, a consulting firm which focused on the energy conservation market for hospitals and schools; and Perfection Fabricators, a sheet metal fabricator for non-ventilation applications. [Pullman Ex. 2, pp. 6-7.]

(e) Beginning in 1982, Pullman attempted to replace its declining nuclear power plant construction business by expanding into the commercial construction markets of Stamford, Connecticut, and Tampa, Miami, and Stuart, Florida. Pullman also added two other business lines in 1984: the manufacture and distribution of a patented fire damper, primarily for use in nuclear power plants; and the installation of “clean rooms”, used for the production of semiconductors and compact discs. [Pullman Ex. 2, pp. 7-8.]

(f) The fire damper line of business remains a strong source of revenue for Pullman, while the clean room division has been discontinued. Shortly after the Chapter 11 case began, Pullman terminated its work on all non-Chicago construction projects, in an effort to focus on its core businesses. [Pullman Ex. 2, pp. 8-9.]

*913 (g) Prior to the commencement of the Chapter 11 case, Pullman experienced substantial financial losses stemming from its non-Chicago commercial construction business. Pullman suffered losses of $3,269,-000 in 1985, $2,919,000 in 1986, and $3,716,-000 during the first four months of 1987. Pullman’s financial difficulties were caused by a combination of factors, including inadequate accounting systems and other internal controls, unqualified supervisory personnel on non-Chicago construction projects, inaccurate job cost estimating, and management’s decision to complete major projects at a loss rather than abandon them. [Pullman Ex. 2, pp 8-9.]

(h) Pullman’s Chapter 11 case was commenced as a result of its significant and continuing financial losses from its Connecticut and Florida operations; increasing pressure from unions, insurance companies, subcontractors and other creditors for payment of past due obligations; and Pullman’s inability to reach a satisfactory agreement to restructure its debt due to the Wells Fargo Bank (the “Bank”). When management’s efforts to effectuate a sale or merger of Pullman proved unsuccessful, Pullman sought relief under Chapter 11. [Pullman Ex. 2, pp. 8-9.]

Pullman’s Post-Petition Operations

5. (a) Pullman has operated much more efficiently since the commencement of its Chapter 11 case, notwithstanding extensive administrative expenses and certain restrictions on its operations due to a Chapter 11 business environment. Soon after the Chapter 11 case was filed, Pullman contracted its business operations by completing the liquidation of its Connecticut and Florida operations. [Pullman Ex. 2, p. 9.]

(b)From May 1, 1987 through April 30, 1989, Pullman had operating income of $1,869,000, extraordinary Chapter 11 expenses of $1,663,000, and write-off from its Florida operations of $120,000, leaving Pullman with net post-petition income of $86,000 (before debt service would be taken into account). [Pullman Ex. 21.] Pullman’s April 30, 1989 balance sheet reflects total assets of $6,754,000, total liabilities of $14,499,000 (including all pre-petition debt) and a negative shareholders’ equity of $7,745,000. [Pullman Ex. 22.]

(c) Since Pullman discontinued its out-of-town operations, it has been able to concentrate on its core businesses. Despite Pullman’s inability to obtain bonding from a commercial surety since the commencement of its Chapter 11 case, Pullman has nevertheless continued to obtain a significant amount of new work, at acceptable profit margins. Pullman has averaged in excess of $1,000,000 of “earned revenue” monthly for the two years in which Pullman has operated under Chapter 11. [Pullman Ex. 21.] Total new sales from May 1, 1987 through April 30, 1989 were in excess of $29 million. [Pullman Ex. 27.]

(d) The continuity of business operations which Pullman ha., enjoyed is due, in part, to the special procedure utilized for the payment of pre-petition lien claims. This procedure was approved by the court early on in the Chapter 11 proceedings and has been successfully implemented. Under this procedure, Pullman has paid $2,549,463 of pre-petition lien claims, without the need for a single hearing. [Pullman Ex. 20.] As a result, Pullman has continued its business operations without interruption or delay and has not been required to abandon any construction project in the Chicago metropolitan area since the commencement of the Chapter 11 case.

(e) Additionally, Pullman assumed many of its pre-petition collective bargaining agreements, namely those with Sheet Metal Workers’ Local 73, Sheet Metal Workers’ Local 265, United Association Local 306, United Association Local 497, United Association Local 507, United Association Local 514 and Plumbers’ Local 130. Pullman has now cured all pre-petition monetary defaults under the assumed collective bargaining agreements and has paid, in aggregate, $801,596 to achieve that result. In addition, Pullman paid approximately $490,-000 to employees after the commencement of the Chapter 11 proceedings on account of pre-petition wages, benefits and related tax claims in order to maintain continuity in the business. Consequently, Pullman *914 presently enjoys an excellent working relationship with all labor organizations and fringe benefit funds necessary for Pullman’s post-confirmation operations, as well as with its non-union employees. [Pullman Ex. 2, p. 11.]

(f) Also during the Chapter 11 case, Pullman reached comprehensive settlements with General Electric Capital Corporation (“GECC”) and Signal Capital Corporation (“Signal”) to restructure long term obligations arising under certain equipment lease agreements. The settlements with GECC and Signal enabled Pullman to retain all of the equipment necessary for its present and future operations at a reduced cost, while returning unneeded equipment. [Pullman Ex. 2, pp. 11-12.]

(g) Additionally, Pullman assumed a modified version of the pre-petition lease agreement for its principal place of business. This lease assumption has resulted in substantial cost savings. Under the assumed modified lease agreement, Pullman is entitled to remain in its present location through the year 2001 at a reasonable rent. [Pullman Ex. 2, p. 12.]

(h) Further, during the Chapter 11 case through June of 1989, Pullman has paid the Bank, or transferred property to it of an aggregate value of $732,000 2 [Pullman Ex. 24] comprised of the following components:

Periodic Adequate Protection Payments $475,000

Liquidation Proceeds of Excess Equipment and Inventory 177,000

Florida Equipment Transfer 80,000

$732,000

PULLMAN’S PLAN

Financing, Management and Capital Structure

6. (a) Pullman’s Plan is premised on new financing of $2.08 million comprised of [Pullman Ex. 3, p. 13]:

New Equity Investment $ 750,000

New Bank Line Credit 1,000,000

New Shareholder Loan 330,000

$2,080,000

(b) The new bank loan of $1,000,000 would be secured by substantially all of Pullman’s assets. It would also be guaranteed by Messrs. Lester and John Goldwyn, two of reorganized Pullman’s shareholders and officers. In addition to their personal guaranty of the new bank loan, Messrs. Lester and John Goldwyn would loan Pullman $330,000. With the exception of current interest, repayment of the shareholder loan would be subordinated to all of Pullman’s Plan obligations. [Pullman Ex. 2, p. 25.]

(c) Pullman’s new equity financing would be provided as follows [Pullman Ex. 2, 19]:

Lester H. Goldwyn $390,000

John P. Goldwyn 225,000

Norma Press Goldwyn . 60,000

Robert F. Cekanor 37,500

George E. Zielinski 18,750

Niranjan S. Choksi 18,750

$750,000

(d) Lester and Norma Goldwyn would be the only stockholders of reorganized Pullman that were also stockholders of Pullman at the commencement of the Chapter 11 case. John P. Goldwyn, Lester Goldwyn’s son, and Messrs. Cekanor, Zie-linski and Choksi are currently officers of Pullman and will become stockholders of reorganized Pullman upon confirmation. [Pullman Ex. 2.]

(e) The hope and opportunity to become stockholders of reorganized Pullman was one of the reasons that Messrs. Cekanor, Zielinski and Choksi continued with Pullman during the Chapter 11 case. In turn, Pullman’s degree of success and stability during the Chapter 11 case are due, in part, to the efforts of Messrs. Cekanor, Zielinski and Choksi.

Treatment of Claims and Interests

(f) The Unclassified Claims. The Plan divides claims into seven classes and equity interests into two classes. Administrative *915 claims 3 and priority tax claims 4 are not classified, see 11 U.S.C. § 1123(a)(1), but Debtors assert that they are treated in accordance with § 1129(a)(9)(A) and § 1129(a)(9)(C) respectively.

(g) The Class 1 Claim. The Class 1 Claim is held by Robertshaw Controls Co. (“Robertshaw”), a mechanics’ lien claimant with respect to the construction of the Sheraton Hotel in Stamford, Connecticut. Robertshaw’s $64,645 mechanics’ lien claim was under the Plan to be satisfied in full by the payment of $48,484 on confirmation. Robertshaw voted its Class 1 Claim to accept the Plan. [Pullman Ex. 6.]

(h) The Class 2 Claims. The Class 2 Claims aggregate approximately $48,000. These claims, held by former employees of Pullman, are entitled to priority under § 507(a)(4). The Plan provides for their payment over a one-year period following confirmation, with twelve percent (12%) interest, pursuant to § 1129(a)(9)(B)(i). The Class 2 creditors also voted to accept the Plan. [Pullman Ex. 7.]

(i) The Class 3 Claim. The Class 3 Claim is held by Signal. This Court has previously held that the Signal Claim is an administrative claim, not entitled to vote on the Plan. While Pullman appealed that ruling, the appeal was dismissed as being taken from an interlocutory order. See Order of Dismissal dated March 29, 1989, entered in 88 C 7743 (N.D.Ill.) (Hart, J.). Thus, the Signal claim’s separate classification, and Signal’s acceptance of the Plan, have no impact on the court’s determination of whether the requirements of § 1129 have been met. Signal did cast a ballot to accept the Plan.

(j) The Class 4 Claim. The Class 4 Claim is the Wells Fargo Bank’s allowed secured claim (the “Bank”). Because the Bank has not made an election under § 1111(b) to have its undersecured claim treated as though it is fully secured, application of § 506(a) is required to divide the Bank’s aggregate pre-petition claim of $8,038,138 into secured and unsecured portions. Debtors contend that the value of the Bank’s Class 4 Claim as of the Plan’s Effective Date, without regard to the value of the Contract Claims or Preference Claims, is $3,274,000, derived as follows [Pullman Ex. 49 and 50]:

Aggregate Value

Most Likely Net Present Value of Free Cash Flows $3,411,000

Excess Cash Excluding Proceeds of Sheraton Claim Settlement Before Reorganization Adjustments 717,000

Sheraton Claim Settlement Proceeds 687,000

Payments/Transfers to Bank During Chapter 11 Case as Adequate Protection 732,000

Most Likely Aggregate Value of Pullman Estate as of the Plan’s Effective Date 5,547,000

Less “Costs to Reorganize” and Priority Lien Claim of Robert-shaw (2,273,000)

Net Value Offered by Plan to the Bank $3,274,000

Debtors’ Plan proposes to pay that sum to the Bank as follows:

Payments/Transfers heretofore made to Bank During Chapter 11 Case as Adequate Protection $ 732,000

Sheraton Claim Settlement Proceeds 687,000

Cash at Confirmation 1,855,000

$3,274,000

Under the Plan the Bank would receive, in full satisfaction of its Class 4 Claim, cash in an amount equal to the value of the Bank’s lien interest in Pullman’s property, less the value of all Pullman’s property transferred to the Bank during the Chapter 11 case ($732,000). That net amount is $2,542,000, including the Sheraton Claim settlement proceeds. In addition, on the Plan’s Effective Date the Bank would receive on account of its Class 4 Claim all “Contract Claims,” the proceeds of all “Preference Claims,” and the right to pros *916 ecute the Preference Claims in Pullman’s name. Those Preference Claims have an aggregate face value in excess of $3,000,-000 [Pullman Ex. 78.], but Debtors have not established their actual or likely value.

The Bank has voted its Class 4 Claim to reject the Plan. Consequently § 1129(b)(2)(A) must be applied for the Plan to be confirmed.

(k) The Class 5 Claim. The Bank did not make an election under § 1111(b) to have its undersecured claim treated as a fully secured claim. Thus, the Class 5 Claim is the Bank’s unsecured claim resulting from the application of § 506(a). The final allowed amount of the Bank’s Class 5 Claim was not to be determined until the Contract Claims and Preference Claims (collectively, the “Claims”) are fully liquidated. Before ascertaining those Claims, the amount of Bank’s Class 5 Claim computed by Debtors is $4,764,138, [Pullman Ex. 61] derived as follows:

Bank’s Aggregate Pre-Petition Claim $8,038,138

Less the amount offered on Bank’s Class 4 Claim (without regard to value of Preference and Contract Claims) (3,274,000)

Bank’s Provisional Class 5 Claim $4,764,138

The Plan proposes to satisfy the Bank’s Class 5 Claim by payment of $131,000 on the Effective Date. This represents an immediate cash dividend of approximately three percent (3%) on account of the Bank’s Class 5 Claim. Should the Bank collect on the Claims, however, the percentage dividend would increase as the amount of the Bank’s Class 5 Claim would decline.

For example, if the Bank were to collect $1,000,000 from the prosecution of the Claims, its allowed Class 4 Claim would increase from $3,275,000 to $4,275,000, and its allowed Class 5 Claim would decline from $4,764,000 to $3,764,000. This would result in an increase of its dividend from three percent (3%) to three and one-half percent (3.5%).

The Bank has voted its Class 5 Claim to reject the Plan. Consequently, application of § 1129(b)(2)(B)(ii) is necessary for the Plan to be confirmed. Because Debtors contend that the full going concern or reorganization value has been attributed to the Bank’s Class 4 (secured) Claim, they argue that any payment on account of the Bank’s Class 5 (unsecured) claim will result in compliance with the fair and equitable standard of § 1129(b)(2)(B)(ii), as the holders of junior Class 8 and 9 equity interests will neither receive nor retain any property under the Plan “on account of such junior interests.”

(l) The Class 6 Claim. Class 6 Claims are all unsecured claims not entitled to priority under § 507, except for the Bank’s Class 5 deficiency claim. Class 6 Claims are generally held by Pullman’s trade creditors and suppliers.

Pullman’s Plan provides for the satisfaction of Class 6 Claims by the payment of six-tenths of one percent (.6%) of Pullman’s “Earned Revenue” 5 for each of the following “Plan Periods”: April-December of 1989; 1990; 1991; 1992; and 1993. Payment of the Class 6 dividend is to be made on or before March 31 of the year following each of the Periods. [Pullman Ex. 1.]

Debtors project that their Earned Revenue for each of the Plan Periods will be as follows [Pullman Ex. 3]:

1989 (9 mos.) $11,164,000

1990 17,479,000

1991 18,785,000

1992 20,356,000

1993 22,387,000

$90,171,000

By application of a six-tenths of one-percent (.6%) multiple, and use of an eighteen percent (18%) discount rate reflecting both risk and the time value of money, Debtors estimate the present value of the contingent Class 6 dividend at $336,000, derived as follows [Pullman Ex. 17]:

*917 Period Revenue Earned Revenue Factor Present Value

1989 (9 mos.) $11,164,000 $ 67,000 0.847 $ 59,000

1990 17,479,000 105,000 0.718 79,000

1991 18,785,000 113,000 0.609 71,000

1992 20,356,000 122,000 0.516 66,000

1998 22,387,000 134,000 0.437 61,000

$90,171,000 $541,000 $336,000

Class 6 Claims are held by more than 800 creditors and total $8 million, of which $4.7 million is disputed. Pullman’s estimate of allowed Class 6 Claims is $6 million. Application of the formula using the net present value of the Class 6 dividend ($336,000) as the numerator, and $6 million as the denominator, results in the calculation of a contingent dividend of approximately five and six-tenths (5.6%).

The Class 6 creditors have voted to accept the Plan. [Pullman Ex. 100.]

(m) The Class 7 Claims. Class 7 claims are held by certain of Pullman’s insiders. These claims total $655,000. Using a dividend factor of five and six-tenths percent (5.6%), the same as the holders of Class 6 Claims would receive, the dividend payable on account of the Class 7 Claims would be $36,680. [Pullman Ex. 18.]

On the other hand, the Class 7 creditors have received transfers aggregating $56,-858, which may be voidable pursuant to § 547. The preference liability of the Class 7 creditors is disputed.

Under the Plan, Class 7 creditors would neither retain nor receive any property on account of their claims, except for a release from their potential but disputed liability under § 547. Given the cost and risk of litigation to recover the potential preferences, plus the fact that the Class 7 creditors are contributing to funding the Plan, Debtors argue that the separate classification and treatment of the Class 7 Claims is justified, does not discriminate unfairly and is fair and equitable in the circumstances.

The Class 7 creditors have voted unanimously to accept the Plan.

(n) Class 8 and 9 Interests. Pullman’s existing common and equity interests are divided into Classes 8 and 9 under the Plan. Debtors argue that under the Plan the holders of these interests will not receive or retain any property “on account of” their interests. On the Plan’s Effective Date, these interests would be cancelled. Consequently, under § 1126(g), the holders of the Class 8 and 9 interests are deemed to have rejected the Plan. Thus, application of § 1129(b)(2)(C) is required to confirm the Plan over the equity interest holders’ deemed rejection.

(o)Plan Funding and Payments on the Effective Date. The following is a summary of the Debtors’ Plan funding sources and required cash payments on the Plan’s Effective Date [Pullman Ex. 65]:

Plan Funding Sources

New bank Line of Credit $1,000,000

Excess Cash, Including Sheraton Settlement Proceeds 1,404,000

Proceeds From Equity Financing 750,000

Proceeds of Shareholder Loan 330,000

Total Cash Available $3,484,000

Cash Payments on the Effective Date

Administrative Expense Escrow $ 560,000

Priority Tax Claims 0

Class 1 48,000

Class 2 0

Class 3 0

Class 4 (Including Sheraton Settlement Proceeds of $687,000) 2,542,000

Class 5 131,000

Class 6 0

Class 7 0

Class 8 0

Class 9 0

Estimated Cash Payments on the Effective Date $3,281,000

Cash Available To Fund Operations and Other Plan Payments $ 203,000

Issues to be Determined

7. This Court must decide the following issues:

*918 a. What is the allowed amount of Wells Fargo’s secured claim, and does the Plan provide Wells Fargo with payments having a present value equal to the allowed amount of its secured claim?

b. Is it proper for the Plan to deduct “Costs to Reorganize” — primarily consisting of pre-petition, unsecured, disputed tax claims and post-petition professional fees— from the aggregate going concern value of Debtors’ existing estate prior to determining the allowed amount of Wells Fargo’s secured claim?

c. Does the “New Capital” exception to the absolute priority rule still exist, and, if so, does the Plan meet that exception?

d. Does the Plan provide, in accordance with 11 U.S.C. § 1129(a)(7), that Wells Fargo will receive, on account of its allowed secured claim, property of a value that is not less than the amount that Wells Fargo would receive if the Debtors were liquidated under Chapter 7?

e. Do the debtors have a reasonable possibility of a successful reorganization in a reasonable time?

8. The range of Debtors’ going concern value argued by the parties is as follows:

a) Creditors’ Committee $3,136,000

b) Debtors’ range $4,490,000 to $5,663,000 [Pullman Ex. 53]

Debtors contend that the most likely value of the estate is $5,547,000. [Pullman Ex. 49.]

c) Wells Fargo’s range $6,626,000 to $7,119,000 [W.F. Ex. 54]

9. The Creditors’ Committee (“Committee”) contends that the going concern value of Debtors’ existing estate, $3,136,000, equals the value of Wells Fargo’s secured claim. Debtors contend that the likely going concern value of Debtors’ existing estate is $5,547,000, but then compute a deduction for $2,273,000 in “Costs to Reorganize,” leaving a value of Wells Fargo’s secured claim in the amount of only $3,274,000. The Debtors argue that the “aggregate value of the existing estate is $5,547,000”, and that this value is “available to pay administrative and pre-petition priority and secured claims.” [Pullman Ex. 49, Note (a).]

10. Wells Fargo contends that the going concern value of the Debtors, and thus its allowed secured claim, ranges from $6,626,000 to $7,119,000. As found herein-below, Wells Fargo has a lien on all assets of the Debtors’ estate.

11. The Debtors and Wells Fargo both utilized expert witnesses to arrive at their conclusion regarding the aggregate value of the existing estate. The Committee did not utilize its own expert witnesses. It elicited little evidence in support of its contention, but relies on the evidence offered by the other parties. This Court finds hereinbelow that the aggregate value of the Debtors’ existing estate, and therefore the amount of Wells Fargo’s allowed secured claim, is $5,000,000.

Wells Fargo Collateral and Claim

12. Wells Fargo has a first priority, properly perfected security interest in and to all assets of the Debtors, including, without limitation, accounts, accounts receivable, contracts, contract rights, inventory, goods, raw material, work in process, patents, machinery and equipment, vehicles, fixtures, improvements, general intangibles and proceeds thereof (the “Collateral”). [W.F. Ex. 38.] Wells Fargo also has a first priority, properly perfected security interest in, and lien upon, all shares of Stock issued by the Debtors. [W.F. Ex. 38.]

13. On March 9, 1988, the Court granted Wells Fargo a “lien on all assets of the [Debtors] including, but not limited to, their post-petition accounts, contract rights, inventory and their proceeds together with an additional lien on [Debtors’] patent and patent rights.” [W.F. Ex. 38.]

14. On August 19, 1988, the Court approved a Settlement Agreement, signed by both Debtors and Wells Fargo, that provided that “Wells Fargo shall have a finally allowed secured claim against the Pullman Companies, and property of the Pullman Companies’ bankruptcy estates, in the amount of $8,038,138.95 ...” [W.F. Ex. 44, p. 3, ¶ 6.]

15. Debtors’ judicial admission also establishes that Wells Fargo has a properly perfected security interest in, and lien *919 upon, all pre-petition and post-petition assets of the Debtors. [W.F. Ex. 46, ¶ 2.]

16. Wells Fargo has a lien on all assets of the Debtors’ existing estates. [W.F. Exs. 38, 39, 40, 44, 46.]

The Dispute as to Going Concern Value

17. Debtors and Wells Fargo cannot agree upon the going concern value of Wells Fargo’s collateral for purposes of establishing the secured portion of Wells Fargo’s allowed claim under 11 U.S.C. § 506(a). Since Wells Fargo has a lien on all of Debtors’ assets, Wells Fargo’s allowed secured claim is equal to the going concern value of Debtors’ assets or estate. The Plan must provide Wells Fargo, on account of its Class 4 secured claim, with payments having a present value equal to the going concern value of Wells Fargo’s collateral.

18. The Plan proposes to satisfy Wells Fargo’s Class 4 secured claim as follows:

a) $ 732,000 - representing cash payments/transfers to Wells Fargo-

b) $ 687,000 - representing the proceeds from the settlement of the “Sheraton Claim.”

c) $1,855,000 - cash payment upon confirmation.

TOTAL $3,274,000 [Pullman Ex. 63]

The factual issue to be resolved is this: Whether the Debtors’ proposed $1,855,000 cash payment at confirmation, or the lesser amount suggested by the Committee, is equal to the going concern value of Wells Fargo’s presently existing collateral? For reasons stated below, the Court finds that the answer is no.

19. This Court previously has found as of the Petition Date that the forced liquidation value of Debtors’ cash, accounts receivable, machinery and equipment and inventory was $3,182,500. [W.F. Exs. 38, 39.] However, this Court has not previously determined the going concern value of Wells Fargo’s collateral.

Book Value of Debtors’ Assets

20. As of June 30, 1989, the book value of Debtor’s assets were:

Cash and Excess Cash $1,117,000

Net Construction Receivables (excluding the Sheraton receivables) 3,250,000

Inventory 465,000

Other Current Assets 366,000

Fixed Assets (Net) 601,000

Other Assets 102,000

TOTAL OF ALL ASSETS $5,901,000

[Pullman Ex. 64.]

Theories and Evidence as to Valuation

21. Pullman’s going concern valuation expert witnesses relied primarily upon a discounted cash flow analysis and have concluded that the appropriate discount rate for Pullman is 18 percent. In reaching this conclusion they employed numerous valuation models and techniques to determine the appropriate discount rate, including: (i) Capital Asset Pricing Model (“CAPM") alternatives; (ii) weighted average cost of capital analyses, (iii) arbitrage pricing theory, and (iv) a survey of selected current investment yields. As additional confirming measures for their valuation results, they also reviewed price/earnings comparisons, earnings before interest and taxes (“EBIT”) comparisons, earnings before depreciation, interest and taxes (“EB-DIT") comparisons, book value comparisons and dividend capitalization model analyses. They agreed on an 18 percent discount rate which, when applied to the anticipated future cash flows set forth in Pullman’s Business Plan, produces what they found to be the most likely net present value of Pullman’s future cash flows. This is one component of Pullman’s aggregate reorganization value, the other being excess cash or non-operative assets. 6

*920 22. Pullman’s expert witnesses on this issue were Harold W. Sullivan, Jr. of Ernst & Whinney and Dr. Robert S. Hamada. Mr. Sullivan utilized the CAPM as well as several other valuation methodologies discussed hereinbelow, while Dr. Hamada used only his refinement of the CAPM approach to validate and corroborate Ernst & Whinney’s conclusion that Pullman’s cost of capital, or the property discount rate, is eighteen percent (18%).

23. Harold Sullivan of Ernst & Whinney testified on behalf of the Debtors that the “most likely value” of the Debtors’ “present value of free cash flows,” based on his use of a discounted cash flow analysis, is $3,411,000. [Pullman Ex. 45.] This analysis was based upon an 18% discount rate. [Pullman Ex. 45.] The $3,411,000 net present value of free cash flows excluded consideration of $2,136,000 of “Non-Operating Items”. [Pullman Ex. 49.]

24. To calculate the most likely aggregate value of the Debtors’ estate, Mr. Sullivan added “Non-Operating Items” total-ling $2,136,000 to his most likely net present value of free cash flows of $3,411,-000. [Pullman Ex. 49.] Mr. Sullivan then concluded that the most likely aggregate value of Debtors’ existing estate is $5,547,-000. [Pullman Ex. 49.] This is the value “available to pay administrative and pre-pe-tition priority and secured claims.” [Id. at Note (a).]

25. Professor Alfred Rappaport defines “corporate value” as the sum of “present value of cash flow from operations during the forecast period plus residual value plus marketable securities.” [Pullman Ex. 89, p. 51.] This definition was essentially followed by experts for both sides. Debtors claim corporate value of $5,547,000 comports with this definition as follows: (a) present value of cash flow from operations during the forecast period — $1,354,000, [Pullman Ex. 45, (present value of free cash flows 1989 through 1993)]; plus, (b) residual value — $2,057,000, [Pullman Ex. 45 (present value of free cash flows after forecast period)]; plus, (c) marketable securities — $2,136,000 [Pullman Ex. 49 (non-operating items)]. Mr. Sullivan testified that these items have a strong or identical correlation to Professor Rappaport’s definition of corporate value. [Tr. pp. 107-110, 6/5/89.]

26.The following is a discussion of each of the valuation approaches utilized by Debtors’ witnesses to determine the most likely value of Pullman’s Aggregate Estate.

a. Discounted Cash Flow

The discounted cash flow method presents value as the sum of a stream of free cash flows from the Plan’s Effective Date into perpetuity. The present value of the cash flows is dependent on the time value of money and the risk of producing the projected cash flows. The projected cash flows are based on Pullman’s Business Plan. Those cash flows include both the projection period through 1993 and the perpetuity period beginning in 1994. Pullman’s experts prepared detailed projections through 1993 because they assumed that by that time Pullman would regain its historical market share and achieve its growth projections. It is found below that if Debt- or were reorganized in 1989, they would gain their maximum market share by 1993. After that, they will be unable to grow further in value because of the competitive nature of the construction industry and the historical inverse relationship between Debtors’ revenues and margins. The evidence does not demonstrate that Pullman can make additional investments after 1993 that will generate returns in excess of its cost of capital.

After gaming its maximum market share, Pullman will not experience further economic growth, even though it may grow in size. The addition of years of projections after 1993 does not demonstrate any real value for purposes of a present valuation. Instead, the residual value of Pullman’s cash flows from 1994 into perpetuity *921 can be determined by the perpetuity method. As Dr. Rappaport explained it,

Using the perpetuity method, the present value (at the end of the forecast period) is therefore calculated by dividing a “perpetuity cash flow” by the cost of capital:

Residual value = Perpetuity cash flow

Cost of capital

Keep in mind that the perpetuity method for estimating residual value is not based on the assumption that all future cash flows will actually be identical. It simply reflects the fact that the cash flows resulting from future investments will not affect the value of the firm because the overall rate of return earned on those investments is equal to the cost of capital.

[Pullman Ex. 89, p. 61]

Pullman’s value is properly calculated discounting each projected annual cash flow through 1993 by the cost of capital and calculating the value of the cash flows thereafter by the perpetuity method as described by Dr. Rappaport.

Once the annual cash flows have been projected, the other important component to be determined is Pullman’s cost of capital or discount rate. Pullman’s experts utilized several methodologies in forming their opinion as to the appropriate discount rate. These methods, which rely in varying degrees upon analyses of publicly-held companies in the construction industry are:

Arbitrage Pricing Theory (“APT") —This is a multi-variable model which estimates cost of capital based on the performance of identified stocks relative to the market as a whole and to selected other stock portfolios. [Pullman Ex. 34.] The APT formulation uses the following portfolios in addition to the market portfolio.

—Large Capitalization Stocks

—Small Capitalization Stocks

—High Cash Flow/Price Stocks

—Low Cash Flow/Price Stocks

Capital Asset Pricing Model (“CAPM") —The CAPM methodology measures a company’s risk relative to the stock market as a whole. Risk is measured as the variability of a stock price relative to a market portfolio. The average historical annual premium of an investment in the market portfolio relative to an investment in an estimated risk-free instrument is adjusted by the variability of the individual stock price relative to the market portfolio (i.e., an estimate of the riskiness of the particular stock or its “beta”). This estimate is added to the current risk-free rate to estimate the rate of return an investor would require on such an investment.

Here, an equally weighted New York Stock Exchange portfolio was analyzed as the “market portfolio” in order better to reflect the performance of both smaller and larger publicly-held companies. A value weighted portfolio (the S & P 500) was also analyzed and adjusted for a small stock premium. The use of CAPM methodology is described below.

Weighted Average Cost of Capital (“WACC”) — WACC is the weighted average of the after-tax cost of debt (i.e., the marginal rate at which a company can borrow funds) and the company’s cost of equity. The cost of debt is tax-effected because of the tax deductions associated with interest payments. Cost of equity has been based on analysis of potential peer companies. The costs are weighted respectively by the ratios of the market values of debt and equity to the market value of total capital (debt plus equity) to derive a weighted average. The results were very similar to those obtained using CAPM methodology. [Pullman Ex. 39, 44.]

Survey of Alternative Investments — A survey of alternative investments currently available in today’s market, evidencing rates of return currently expected by investors, was also made to determine Pullman’s cost of capital. [Pullman Ex. 32, 33, 34.]

b. Peer Group Multiple Analyses

In order to confirm their discounted cash flow valuation findings, Pullman’s experts analyzed certain multiples of financial data for other companies. Although this analysis was not performed in the same depth as the discounted cash flow analysis, and it is not entitled to the same weight because of its reliance on accounting-based numbers, *922 it serves to corroborate results of the cash flow analysis. This multiple analysis, which was performed on publicly-held companies in the construction industryh included:

Price-Earnings Multiple (“P/E”) —“Earnings” is defined as operating earnings after taxes. The respective median P/E multiples for the Peer Group were estimated to be 11.79 and 9.86. These multiples were applied to Pullman’s actual 1988 and projected 1989 operating earnings to calculate a range of potential values. [Pullman Ex. 54.]

EBIT Multiple —“EBIT” is earnings before interest and taxes. The median Peer Group EBIT multiple was estimated to be 6.06. This multiple was applied to PCI’s 1988 actual earnings before interest and taxes to calculate a potential value. [Pullman Ex. 56.]

EBDIT Multiple —“EBDIT” is earnings before depreciation, interest and taxes. The median EBDIT multiple for the Peer Group was 5.03. This multiple was applied to PCI’s 1988 earnings before depreciation, interest and taxes to calculate a potential value. [Pullman Ex. 57.]

Book Value Multiple — Book value is the excess of the net book value of the assets over the net book value of the liabilities (i.e., stockholder’s equity). The Peer Group companies’ median book value multiple was estimated to be 1.38. Pullman’s net book value was calculated both before and after the new equity investments, and those figures were multiplied by the median book value multiple to estimate potential values. [Pullman Ex. 59, 60.]

All of these multiple analyses were adjusted by reconciling items to make estimates of Pullman’s gross reorganization value.

c. Dividend Capitalization

Another confirming technique employed was the dividend capitalization model, which assumes that dividends are a constant stream of cash flows to equity investors. The present value of a stream of equal cash flows, or an annuity, is the cash flow divided by the discount rate. The discount rate is calculated as described above in the Discounted Cash Flow Approach Summary. Items were added to this calculated value to reconcile to the reorganization value. [Pullman Ex. 58.]

d. The Synthesis of the Various Techniques Used

In addition to these confirming techniques, Pullman’s experts considered certain other factors, including the following: (i) Pullman is privately-held and does not have access to public capital markets; (ii) achieving the Business Plan’s objectives is dependent on the continued involvement of a few key managers; (iii) Pullman has been in bankruptcy; (iv) the construction industry is very dependent upon personal relationships and a substantial portion of Pullman’s good will and value resides in the Goldwyns; and (v) Pullman operates in a single localized market, not a regional or national market. Finally, Pullman’s experts weighed the strengths and weaknesses of each of the methodologies employed in forming their opinions that 18% is the appropriate discount rate and that the most likely gross value of Pullman’s aggregate estate is $5,547,000.

Application of the various confirming techniques produced the following range of values of Pullman’s Aggregate Estate [Pullman Ex. 53]:

Priee/Earnings Multiple on Fore-casted 1989 Earnings $4,490,000

Book Value Multiple Before New Equity Investment $4,693,000

Dividend Capitalization Model $4,803,000

Price/Earnings Multiple on EBIT $4,815,000

Price/Earnings Multiple on EBDIT $4,882,000

Book Value Multiple After New Equity Investment $5,390,000

Price/Earnings Multiple on Pre-Confirmation 1988 Earnings $5,663,000

CAPM Methodology

The principal technique employed by both Ernst & Whinney and Dr. Hamada to determine the discount rate was CAPM. CAPM methodology recognizes that different investments have different levels of risk and, therefore, should produce different returns to investors. The CAPM method measures the risk associated with a *923