978-1305637108 Chapter 24 Solution Manual Part 1

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

100%

Accounts payable

375,000

100

Subordinated

debentures

750,000

100

$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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