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
3. A prepackaged bankruptcy is where the firm and most creditors agree to a private reorganization before
4. Just because a firm is experiencing financial distress doesn’t necessarily imply the firm is worth more
dead than alive.
6. The absolute priority rule is the priority rule of the distribution of the proceeds of the liquidation. It
7. Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt. This new debt
8. One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts
9. As in the previous question, it could be argued that using bankruptcy laws as a sword may be the best
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
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
1. Under the absolute priority rule (APR), claims are paid out in full to the extent there are assets. In this
case, assets are $35,600, so you should propose the following:
Distribution of
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
Mortgage bonds
Senior debenture
Senior debentures
Junior debenture
Junior debentures
Equity
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 = 7,800($31) = $241,800
We also need the book value of debt. Since we have the value of total assets and the book value of
4. Since this company is private, we must use the Z-score for private companies and non-manufacturers,
which is: