CHAPTER 30

FINANCIAL DISTRESS


Answers to Concepts Review and Critical Thinking Questions


1. Financial distress is often linked to insolvency. Stock-based insolvency occurs when a firm has a
negative net worth. Flow-based insolvency occurs when operating cash flow is insufficient to meet
current obligations.

2. Financial distress frequently can serve as a firms early warning sign for trouble. Thus, it can be
beneficial since it may bring about new organizational forms and new operating strategies.

3. A prepackaged bankruptcy is where the firm and most creditors agree to a private reorganization
before bankruptcy takes place. After the private agreement, the firm files for formal bankruptcy. The
biggest advantage is that a prepackaged bankruptcy is usually cheaper and faster than a traditional
bankruptcy.

4. Just because a firm is experiencing financial distress doesnt necessarily imply the firm is worth
more dead than alive.

5. Liquidation occurs when the assets of a firm are sold and payments are made to creditors (usually
based upon the APR). Reorganization is the restructuring of the firm's finances.

6. The absolute priority rule is the priority rule of the distribution of the proceeds of the liquidation. It
begins with the first claim to the last, in the order: administrative expenses, unsecured claims after a
filing of involuntary bankruptcy petition, wages, employee benefit plans, consumer claims, taxes,
secured and unsecured loans, preferred stocks and common stocks.

7. Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt. This new
debt is called DIP (debtor in possession) debt. If DIP loans were not senior to all other debt, a firm in
bankruptcy would be unable to obtain financing necessary to continue operations while in
bankruptcy since the lender would be unlikely to make the loan.

8. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts
in shareholders best interest by managing this asset in ways that maximize its value. To the extent
that a bankruptcy filing prevents a race to the courthouse steps, it would seem to be a reasonable
use of the process.

9. As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be
the best use of the asset. Creditors are aware at the time a loan is made of the possibility of
bankruptcy, and the interest charged incorporates it. If the only way a firm can continue to operate is
to reduce labor costs, it may be a benefit to everyone, including employees.
10. There are four possible reasons why firms may choose legal bankruptcy over private workout: 1) It
may be less expensive (although legal bankruptcy is usually more expensive). 2) Equity investors
can use legal bankruptcy to hold out. 3) A complicated capital structure makes private workouts
more difficult. 4) Conflicts of interest between creditors, equity investors and management can make
private workouts impossible.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. Under the absolute priority rule (APR), claims are paid out in full to the extent there are assets. In
this case, assets are $28,500, so you should propose the following:

Original claim
Distribution of
liquidating value
Trade credit $4,800 $4,800
Secured mortgage notes 8,000 8,000
Senior debentures 10,000 10,000
Junior debentures 15,000 5,700
Equity 0 0

2. There are many possible reorganization plans, so we will make an assumption that the mortgage
bonds are fully recognized as senior debentures, the senior debentures will receive junior debentures
in the value of 65 cents on the dollar, and the junior debentures will receive any remaining value as
equity. With these assumptions, the reorganization plan will look like this:

Original claim Reorganized claim
Mortgage bonds $19,000 Senior debenture $19,000
Senior debentures 9,500 Junior debenture 6,175
Junior debentures 7,500 Equity 1,825

3. Since we are given shares outstanding and a share price, the company must be publicly traded. First,
we need to calculate the market value of equity, which is:

Market value of equity = 5,000($18) = $90,000

We also need the book value of debt. Since we have the value of total assets and the book value of
equity, the book value of debt must be the difference between these two figures, or:

Book value of debt = Total assets Book value of equity
Book value of debt = $42,000 19,000
Book value of debt = $23,000

Now, we can calculate the Z-score for a publicly traded company, which is:

Z-score = 3.3(EBIT/Total assets) + 1.2(NWC/Total assets) + 1.0(Sales/Total assets)
+ .6(Market value of equity/Book value of equity)
+ 1.4(Accumulated retained earnings/Total assets)

Z-score = 3.3($6,500/$42,000) + 1.2($3,100/$42,000) + ($61,000/$42,000) + .6($90,000/$19,000)
+1.4($13,500/$42,000)
Z-score = 5.344

4. Since this company is private, we must use the Z-score for private companies and non-
manufacturers, which is:

Z-score = 6.56(NWC/Total assets) + 3.26(Accumulated retained earnings/Total assets)
+ 1.05(EBIT/Total assets) + 6.72(Book value of equity/Total liabilities)
Z-score = 6.56($6,800/$75,000) + 3.26($19,000/$75,000) + 1.05($8,300/$75,000)
+ 6.72($26,000/$49,000)
Z-score = 5.103