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Answers and Solutions: 24-1
Chapter 24
Bankruptcy, Reorganization, and Liquidation
24-1 a. Informal debt restructuring is the agreement between the creditors and troubled firm
to change the existing debt terms. An extension postpones the required payment date,
while a composition is a reduction in creditor claims. Extension provides payment in
b. Assignment is an informal procedure for liquidating debts which transfers title to a
debtor's assets to a third person, known as an assignee or trustee. Assignment
normally yields creditors a larger amount than they would receive in a formal
bankruptcy. However, an assignment does not automatically result in a full and legal
discharge of all the debtor's liabilities, nor does it protect the creditors against fraud.
Liquidation is the sale of the assets of a firm and the distribution of the proceeds to
the creditors and owners in a specific priority. The decision whether to reorganize or
liquidate should be based on the value of the firm if it is rehabilitated versus the value
of the assets if they are sold off individually. The procedure that promises higher
the priority of each claim, regardless of the consequence to other claimants. The
relative priority doctrine is more flexible and gives a more balanced consideration to
all claimants than does the absolute priority doctrine.
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bankruptcy proceedings. This law represents a shift to a relative priority doctrine of
creditors' claims. Chapter 11 of the Bankruptcy Act is the business reorganization
chapter. Under this chapter, a case is started when a firm's management or its
creditors file a petition with the bankruptcy court. A committee of unsecured
distribution of the debtor's assets among the creditors, and (3) it allows insolvent
debtors to discharge all their obligations and to start new businesses unhampered by
a burden of prior debt.
accepting equity in place of debt, or some combination of these changes. Workouts
are voluntary reorganization plans arranged between creditors and generally sound
companies experiencing temporary financial difficulties. Workouts typically require
some restructuring of the old firm's debt. Cramdowns are bankruptcy court-mandated
Answers and Solutions: 24-3
24-2 The rehabilitation plan may be accepted because of the following:
value.
24-3 Not necessarily. The going-concern value of a firm is a function of its outlook--it might
24-4 Liquidations usually result in losses for the following reasons:
Because the claims of numerous parties must be adjudicated, considerable
Failure to institute the necessary operating and management changes might cause
24-5 Because public utilities and railroads often involve essential services, reorganizations and
mergers rather than liquidations are likely to take place. This is less true for industrial
companies.
Answers and Solutions: 24-4
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
24-1 Distribution of proceeds on liquidation:
1. Proceeds from sale of assets $2,500,000
2. First mortgage, paid from sale of assets 0
3. Fees and expenses of administration of bankruptcy 281,250
Distribution to general creditors:
Claims of General
Creditors
Claim
(1)
Application
of 100%
Distribution
(2)
After
Subordination
Adjustment
(3)
Percentage
of Original
Claims
Received
(4)
Notes payable
$ 750,000
$ 750,000
$ 750,000
100%
Accounts payable
375,000
375,000
375,000
100
Subordinated
debentures
750,000
750,000
750,000
100
$1,875,000
$1,875,000
$1,875,000
The remaining $2,218,750 – $1,875,000 = $343,750 will go to the common stockholders.
They will receive only $343,750/$1,875,000 = 18.33% of the amount of equity on the balance
sheet.
24-2 a. The pro forma balance sheet follows (in millions of dollars):
Current assets $159a Current liabilities $ 42
Net fixed assets 153 Advance payments 78
Goodwill 15 Reserves 6
(6,000,000 shares) 9
Retained earnings 57
Total assets $327 Total claims $327
Notes:
Net operating income $ 24.0
Other income 3.0
EBIT $ 27.0
Interest expense 7.2a
a0.08($90 million par value) = $7.2.
b$2.40(1.2 million shares) = $2.9.
Thus, the increase in income available to common shareholders is $7.0 - $5.7 = $1.3
million.
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c. The earnings required before the recapitalization is $7.8 million/(1 - 0.5) = $15.6
million. We divide the preferred dividends by (1 - T) since $15.6 million must be
earned to provide the $7.8 million needed after-tax. After recapitalization, the firm
requires $2.9 million/0.5 = $5.8 million to cover the preferred dividend payment, and
After reorganization the debt ratio is $210 million/$327 million = 0.642 = 64.2%.
Note that advance payments by customers are counted as debt while reserves are not.
If preferred stock is treated as debt, the debt ratio actually declines slightly from 78.6
percent to 78.0 percent. The reorganization is in the best interests of the shareholders
24-3 a. Creditor claims total $1,100,000 while the trustee has an additional $50,000 in claims,
yet the liquidation produced only $600,000 in proceeds. Since the proceeds are
insufficient to satisfy the creditor and trustee claims, the shareholders receive nothing.
b. The mortgage bondholders have priority claim against the proceeds from the sale of
pledged property. Thus, the $400,000 from the fixed assets must first be distributed
to the first and second mortgage bondholders. The first mortgage holders receive their
c. The priority claimants are the mortgage bondholders, trustee, workers, and
government. The remaining claimants are general creditors. There is $200,000
available after the $400,000 distribution to the mortgage bondholders. This is
distributed to the remaining priority claimants as follows:
Answers and Solutions: 24-7
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d. Of the total $600,000 received from the liquidation, $520,000 has been distributed to
priority claimants. This leaves $80,000 to distribute to the general creditors. But the
general creditor claims total $630,000:
Account Claim
Accounts payable $ 50,000
Notes payable 180,000
Second mortgage bonds 100,000
Debentures 200,000
Account Amount Received
Accounts payable $ 6,350
Notes payable 22,860
Second mortgage bonds 12,700 (plus $100,000)
payable holders are $180,000 - $22,860 = $157,140 short of being fully satisfied, the
full $12,700 initially allocated to the subordinated debenture holders must be
relinquished to the notes payable holders resulting in $22,860 + $12,700 = $35,560
for the notes payable holders and nothing (of the general creditor portion) for the
24-4 a. The total amount available for distribution is $3,190,000 proceeds + $10,000 cash =
$3,200,000. The total creditor and trustee claims are $6,800,000 + $200,000 =
$7,000,000. Since the claims far exceed the available funds, preferred and common
stockholders will receive nothing.
Taxes payable 50 50 50 100
Mortgage bonds 1,600 1,696 1,696 85
Subordinated
Debentures 600 220 9
After the general creditor distribution, notes payable is $500 - $120 = $380 short.
Therefore, subordinated debentures must give up $380, leaving $600 - $380 =
$220.
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