CHAPTER 30 –
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
2. Financial distress frequently can serve as a firm’s “early warning” sign for trouble. Thus, it can be
3. A prepackaged bankruptcy is where the firm and most creditors agree to a private reorganization
4. Just because a firm is experiencing financial distress doesn’t necessarily imply the firm is worth
5. Liquidation occurs when the assets of a firm are sold and payments are made to creditors (usually
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
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
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
9. As in the previous question, it could be argued that using bankruptcy laws as a sword may be the
best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy,
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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
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 $31,400, so you should propose the following:
Original claim
Distribution of
liquidating value
Trade credit $4,700 $4,700
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
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:
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:
Now, we can calculate the Z-score for a publicly traded company, which is:
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Z-score = 3.3(EBIT / Total assets) + 1.2(NWC / Total assets) + 1.0(Sales / Total assets)
Z-score = 3.3($7,300 / $95,000) + 1.2($3,800 / $95,000) + ($104,000 / $95,000)
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)
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