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22-1 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
full, though delayed. Conversely, composition involves a reduced cash settlement.
Restructuring often involves both extension and composition. A reorganization in
bankruptcy is a court-approved attempt to keep a company alive by changing its
capital structure. A reorganization must adhere to the standards of fairness and
feasibility.
c. The absolute priority doctrine states that claims must be paid in strict accordance with
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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Answers and Solutions: 22-1
d. The Bankruptcy Reform Act of 1978 was enacted to speed up and streamline
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
creditors is then appointed by the court to negotiate with the firm's management.
Existing management may stay in office unless a trustee is appointed by the court. If
no fair and feasible reorganization can be worked out, the firm will be liquidated
under the procedures spelled out in Chapter 7 of the act. Chapter 7 of the Federal
Bankruptcy Reform Act accomplishes three important tasks during a liquidation: (1)
it provides safeguards against fraud by the debtor, (2) it provides for an equitable
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.
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• The going-concern value of a firm is always substantially greater than its liquidating
value. Hence, to preserve the life of the firm is to preserve a substantial portion of its
value.
• On balance, the creditors will accept a plan for financial rehabilitation because it
appears that the funds they will receive will be much larger under this procedure.
22-3 Not necessarily. The going-concern value of a firm is a function of its outlook--it might
be improved by changing the management or otherwise improving operations. The firm
may be temporarily distressed.
• Assets typically have characteristics which make their value in existing uses greater
than when resold.
• Failure to institute the necessary operating and management changes might cause
losses to continue and might cause further deterioration in the value of the company.
It is often said that a swift major "surgery" for a business firm is preferred to an
extended illness.
22-5 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.
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Answers and Solutions: 22-3
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
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Notes:
a
$168 less $9 used to retire the $10.50 preferred stock.
b
(1.2 million shares)($75 par value) = $90.
c
(1.2 million shares)($37.50 par value) = $45.
Notes:
a
0.08($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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Answers and Solutions: 22-5
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
$7.2 million to cover the interest expense for a total of $13.0 million. Since interest
expense is tax deductible, only $7.2 million in pre-tax earnings are required to cover
the interest expense. Thus, required earnings will decrease by $15.6 million - $13.0
million = $2.6 million if the reorganization takes place.
d. The debt ratio before reorganization is $120 million/$336 million = 0.357 = 35.7%.
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
because under reorganization (1) earnings to shareholders are increased, (2) earnings
required to cover fixed charges (including preferred dividends) are decreased, and (3)
income debentures are less risky to the shareholders than preferred stock.
22-3 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
full claim of $300,000, while the second mortgage holders receive the remaining
$100,000. This constitutes the total $400,000, so none of the proceeds from the sale
of pledged assets are available for distribution to general creditors. Additionally, the
second mortgage holders have $100,000 in unsatisfied claims which become general
creditor claims.
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:
Claimant Amount
Trustee's expenses $ 50,000
Workers' wages due 30,000
Governments' taxes due 40,000
Total $120,000
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Account Claim
Accounts payable $ 50,000
Notes payable 180,000
Second mortgage bonds 100,000
Debentures 200,000
Subordinated debentures 100,000
Total $630,000
Note that the second mortgage holders' unsatisfied claim of $100,000 is included.
Each claimant, before subordination adjustment, would receive $80,000/$630,000 =
0.1270 of his or her claim. Therefore, the general creditors would receive:
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Answers and Solutions: 22-7
22-4 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.
b. The following table shows the liquidation distribution (in thousands of dollars):
• 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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22-5 The detailed solution for the spreadsheet problem, Solution to Ch22 P05Build a
Model.xls, is available on the textbook’s Web site.
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to a publicly accessible website, in whole or in part.
Answers and Solutions: 22-9
MINI CASE
Answer: The major causes of business failure consist of economic factors, such as industry
weakness and poor location, and financial factors, such as too much debt and
insufficient capital. However, most business failures occur because a number of
factors combine to make the business unsustainable.
Answer: A fairly large number of businesses fail each year, but the number in any one year
has never been a large percentage of the total business population. The failure rate of
businesses, however, has tended to fluctuate with the state of the economy.
a. 3. Which size of firm, large or small, is more prone to business failure? Why?
Answer: Bankruptcy is more frequent among smaller firms. While bankruptcy does occur in
large firms, they tend to get more help from external sources to avoid it, given their
greater impact on the economy and, in the case of large financial institutions, the
financial world. The federal government's bailouts of Chrysler and Lockheed are
good examples of this external assistance.
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to a publicly accessible website, in whole or in part.
Mini Case: 22 - 10
b. What key issues must managers face in the financial distress process?
Answer: As a manager begins to face financial distress, he or she must begin to consider the
following key issues:
• Should the firm file for bankruptcy, or should it try to use informal procedures?
Obviously, answers to these questions are needed to chart the course of the firm while
under financial distress.
Answer: When faced with financial distress, it is often desirable for firms to pursue informal
reorganizations or liquidations with creditors, given the costs associated with legal
bankruptcy. Creditors generally prefer informal reorganization plans when dealing
with economically sound companies whose financial difficulties appear to be
temporary. These voluntary informal plans, commonly called workouts, tend to
involve some type of restructuring, where current debt terms are revised to facilitate
the firm's ability to make payments. Such restructurings typically involve extension
and/or composition. In an extension, creditors postpone the dates of required interest
or principal payments, or both. Creditors tend to prefer extensions when developing
reorganization plans because they promise eventual payment in full. In a
composition, creditors voluntarily reduce their fixed claims on the debtor by either
accepting a lower principal amount or accepting equity in place of debt. This can be
a desirable alternative if bankruptcy becomes a real possibility, since composition can
help the creditor and debtor avoid the many costs associated with legal bankruptcy.
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to a publicly accessible website, in whole or in part.
Mini Case: 22 - 11
Informal liquidations can also be used if it is decided that the firm is worth more
by selling it off in pieces. Assignment is an informal procedure for liquidating a firm.
It calls for title to the debtor's assets to be transferred to a third party, known as the
assignee or trustee. The assignee is required to liquidate the firm's assets either
through a private sale or a public auction, and then to distribute the proceeds among
the firm's creditors on a pro rata basis.
Answer: U. S. Bankruptcy laws were first enacted in 1898 to ensure that businesses worth
more as ongoing concerns were not shut down by individual creditors desiring
liquidation and full payment. The Bankruptcy Reform Act Of 1978 revised these
laws to streamline and expedite bankruptcy proceedings. Current bankruptcy law
consists of eight chapters, the most important of which are Chapter 7, which details
the procedures to be followed when liquidating a company, and Chapter 11, the
business reorganization chapter. When a petition for bankruptcy is filed in federal
court, the petition can be either voluntary or involuntary. A voluntary petition is filed
by the distressed firm's management; an involuntary petition is filed by its creditors.
The court will appoint a committee of unsecured creditors to negotiate a
reorganization, which may include restructuring. A trustee will be appointed if
current management is incompetent or fraud is suspected; otherwise the existing
management will retain control. If no fair and feasible reorganization can be worked
out, then the firm will be liquidated under Chapter 7 procedures.
Answer: There are many differences between voluntary reorganizations and reorganizations in
bankruptcy. Voluntary reorganizations are far less costly and relatively simple to
create as compared to reorganizations in bankruptcy. As a result, voluntary
reorganizations typically allow creditors to recover more money, and sooner, than
they would under legal bankruptcy. However, reorganizations in bankruptcy have
their advantages. First, they avoid holdout problems which can arise with voluntary
reorganizations (which occur when all creditors do not agree to the voluntary plan).
Second, because of the automatic stay provision, bankruptcy avoids the common pool
problem, where efforts to foreclose on the firm by one creditor cause the remaining
creditors to initiate foreclosure as well. Automatic stay, which is granted to all firms
in bankruptcy, limits creditors' abilities to foreclose unilaterally on the firm to collect
their claims. Third, under bankruptcy, interest and principal payments may be
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Mini Case: 22 - 12
delayed without penalty until a reorganization plan is approved. Fourth, bankruptcy
permits the firm to issue debtor in possession (dip) financing to enhance the ability of
the firm to borrow funds for short-term liquidity purposes. Finally, bankruptcy gives
the debtor exclusive right to submit a proposed reorganization plan for agreement
from the parties affected.
While bankruptcy gives the firm a chance to work out its problems without the
threat of creditor foreclosure, it does not give the debtor free reign over the firm's
assets. First, bankruptcy law gives creditors the right to petition the bankruptcy court
to block almost any action the firm might take while in bankruptcy. Second,
fraudulent conveyance statutes, which are part of debtor-creditor law in most states,
protect creditors from unjustified transfers of property by a firm in financial distress.
In bankruptcy, it is much easier to gain acceptance of a reorganization plan,
because the bankruptcy court will lump the creditors into classes. Each class is
considered to have accepted a reorganization plan if a majority of the creditors in the
class (holding at least two-thirds of the amount of debt) vote for the plan, and the plan
will be approved by the court if it is deemed to be "fair and equitable" to the
dissenting parties. This procedure, in which the court mandates a reorganization plan
in spite of dissent, is called a cramdown.
Answer: Chapter 7 of the federal bankruptcy reform act provides for an equitable distribution
of the debtor's assets among the creditors. The distribution of assets is governed by
the following priority of claims:
• Secured creditors (who are entitled to the proceeds of the sale of specific property
pledged for a lien or a mortgage).
• Expenses incurred after an involuntary case has begun but before a trustee has
been appointed.
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Mini Case: 22 - 13
• Wages due workers if earned within three months prior to filing of the petition in
bankruptcy.
• Claims for unpaid contributions to employee benefit plans that should have been
paid within six months prior to filing.
• Taxes due to federal, state, county, and any other government agency.
• Preferred stockholders.
• Common stockholders.
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to a publicly accessible website, in whole or in part.
Mini Case: 22 - 14
h. Assume that Russ Brothers did indeed fail, and that it had the following balance
sheet when it was liquidated (in millions of dollars):
For simplicity, assume that there were no trustee's fees or any other claims
against the liquidation proceeds. Also, assume that the mortgage bonds are
secured by the entire amount of fixed assets. What would each claimant receive
from the liquidation distribution?
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to a publicly accessible website, in whole or in part.
Mini Case: 22 - 15
Answer: The following table shows the liquidation distribution (millions of dollars):
Distribution to Priority Claimants
(in millions)
Distribution Percentage
Gen’l creditor Amt. Of pro rata after subord. Original claim
claims claim distrib.1 adjustment received
1st mortgage $ 0.5 $ 0.325 $ 0.325 94%
2nd mortgage 0.5 0.325 0.325 65
Notes payable 5.0 3.250 5.000 100
Accts. Payable 10.0 6.500 6.500 65
Subord. Deben.2 4.0 2.600 0.850 21
Total $20.0 $13.000 $13.000
Notes:
1. $13 million is available for distribution to general creditors; however, there is $20
million in general creditor claims, so the pro rata distribution will be $13/$20 =
0.65, or 65 cents on the dollar.
2. The debentures are subordinated to the notes payable. The amount of the
unsatisfied notes payable is $5.0-$3.25=$1.75 million.
$1.75 million is reallocated from the subordinated debentures to notes payable.
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Mini Case: 22 - 16