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 negative net worth. Flow-based insolvency occurs when operating cash flow is insufficient to meet current obligations.

2                    Financial distress frequently can serve as a firm’s “early warning” sign for trouble. Thus, it can be beneficial since it may bring about new organizational forms and new operating strategies.  

3                    A prepackaged bankruptcy is where the firm and most creditors agree to a private reorganization before bankruptcy takes place. After the private agreement, the firm files for formal bankruptcy. The biggest advantage is that a prepackaged bankruptcy is usually cheaper and faster than a traditional bankruptcy.

4                    Just because a firm is experiencing financial distress doesn’t necessarily imply the firm is worth more dead than alive.

5                    Liquidation occurs when the assets of a firm are sold and payments are made to creditors (usually based upon the APR). Reorganization is the restructuring of the firm's finances.

6                    The absolute priority rule is the priority rule of the distribution of the proceeds of the liquidation. It begins with the first claim to the last, in the order: administrative expenses, unsecured claims after a filing of involuntary bankruptcy petition, wages, employee benefit plans, consumer claims, taxes, secured and unsecured loans, preferred stocks and common stocks.

7                    Bankruptcy allows firms to issue new debt that is senior to all previously incurred debt. This new debt is called DIP (debtor in possession) debt. If DIP loans were not senior to all other debt, a firm in bankruptcy would be unable to obtain financing necessary to continue operations while in bankruptcy since the lender would be unlikely to make the loan.

8                    One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts in shareholders’ best interest by managing this asset in ways that maximize its value. To the extent that a bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable use of the process. 

9                    As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be the best use of the asset. Creditors are aware at the time a loan is made of the possibility of bankruptcy, and the interest charged incorporates it. If the only way a firm can continue to operate is to reduce labor costs, it may be a benefit to everyone, including employees.

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 use legal bankruptcy to “hold out.” 3) A complicated capital structure makes private workouts more difficult. 4) Conflicts of interest between creditors, equity investors and management can make private workouts impossible.


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 manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.


1                    Under the absolute priority rule (APR), claims are paid out in full to the extent there are assets.  In this case, assets are $15,500, so you should propose the follows.

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:


Distribution of

Original claim

liquidating value

Trade credit



Secured mortgage notes



Senior debentures



Junior debentures







Original claim Reorganized claim Mortgage bonds $10,000 Senior debenture  $10,000 Senior debentures $6,000 Junior debenture  $3,900 Junior debentures $4,000 Equity $1,100