Chapter 31: Financial Distress

Questions and Problems:

31.1 Under the absolute priority rule (APR), claims are paid out in full to the extent there are assets. In this case,
assets are $28,500, so you should propose the following:

Distribution of
  Original claim liquidating value
Trade credit $4,800 $4,800
Secured mortgage notes 8,000 8,000
Senior debentures 10,000 10,000
Junior debentures 15,000 5,700
Equity 0 0

31.2 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
Mortgage bonds $19,000 Senior debenture $19,000
Senior debentures 9,500 Junior debenture 6,175
Junior debentures 7,500 Equity 1,825

31.3 The mortgage bonds are secured by the buildings and would receive the $14 billion proceeds from the
building. The remaining $16 billion claim would be included with unsecured creditors.

Amount remaining after administrative costs, other expenses and secured claims:
$11.6 billion = $30 billion - $14 billion - $4.4 billion

The unsecured creditors would share the residual on a proportional basis after paying administrative costs.

Claims Proposed Distribution

($ billions) ($ billions)
Admin. Costs & other $4.4 $ 4.4
Mortgage bonds $14 (= $28-$14) $3.3 (=$11.6 *($14/($14+$35)))
Subordinated debentures $35 $8.3 (=$11.6 *($35/($14+$35)))
Shareholders ------ -------
$16

An amount of $4.4 billion is used to cover administrative costs and other expenses. In total, the holders of
mortgage bonds will receive 14 + 3.3 = $17.3 billion. The holders of subordinated debentures will receive $8.3
billion. Finally, shareholders will receive nothing.

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

© 2019 McGraw-Hill Education Ltd.
31-1
31.4 There are many potential reorganization plans. One example:

(in billions)
Assets Claims
Going Concern Value $37 Debentures $23
Equity 14
Total $37 Total $37

The holders of mortgage bonds would receive debentures for $23 billion and the holders of the subordinated
debentures would receive equity worth $14 billion. In both cases the value is greater than they would have
received in a liquidation. This derives from the fact that the firm’s going concern value exceeds its liquidation
value.

31.5 $850,000 would be used to pay the administrative fees and other claims. The bond holders would receive $5.6
million and the equity holders would receive $7.55 million.

Ross et al, Corporate Finance 8th Canadian Edition Solutions Manual

© 2019 McGraw-Hill Education Ltd.
31-2