Deck 29: Financial Distress

Question 1

Priority of Claims, which of the following has the highest general priority?

A)Tax Claims.
B)Consumer Claims.
C)Wages, salaries and commisions.
D)Preference shareholder claims.
E)Ordinary shareholder claims.

Answer 1

Wages, salaries and commisions.

Question 2

What is the absolute priority rule of the following claims once a corporation is determined to be bankrupt?

A)Administrative expenses, wages claims, government tax claims, debtholder and then Equityholder claims.
B)Administrative expenses, wages claims, government tax claims, equityholder and then Debtholder claims.
C)Wage claims, administrative expenses, debtholder claims, government tax claims and Equityholder claims.
D)Wage claims, administrative expenses, debtholder claims, equityholder claims and Government tax claims.
E)None of the above.

Answer 2

Administrative expenses, wages claims, government tax claims, debtholder and then Equityholder claims.

Question 3

Perhaps equally, if not more damaging, are the indirect costs of financial distress.Some examples of indirect costs are:

A)Loss of current customers.
B)Loss of business reputation.
C)Management consumed in survival and not on a strategic direction.
D)A, B and C.
E)Both A and B.

Answer 3

A, B and C.

Question 4

The net payoff to creditors in formal bankruptcy may be low in present value terms because:

A)the financial structure may be complicated with several groups and types of creditors.
B)indirect costs of bankruptcy may have been costly in lost revenues and poor maintenance.
C)administrative costs are high and increase with the complexity and length of time in the
Formal bankruptcy process.
D)stopping pre-bankruptcy interest on unsecured debt helps the shareholders but hurts the
Creditors.
E)All of the above.

Question 5

A firm that has a series of negative earnings, sales declines and workforce reductions is likely head to:

A)a change in management.
B)a merger.
C)financial distress.
D)new financing.
E)None of the above.

Question 6

A firm in financial distress that reorganizes:

A)continues to run the business as a going concern.
B)must have acceptance of the plan by the creditors.
C)may distribute new securities to creditors and shareholders.
D)may merge with another firm.
E)All of the above.

Question 7

In a prepackaged bankruptcy the firm:

A)and creditors agree to a private reorganization outside formal bankruptcy.
B)must reach agreement privately with most of the creditors.
C)will have difficulty when there are thousands of reluctant trade creditors.
D)an arrangement under which the sale of all or part of a company's business or assets is
Negotiated with a purchaser prior to the appointment of an administrator.
E)All of the above.

Question 8

Firms deal with financial distress by:

A)selling major assets.
B)merging with another firm.
C)issuing new securities.
D)exchanging debt for equity.
E)All of the above.

Question 9

Equityholders may prefer a formal bankruptcy filing because:

A)the firm can issue debtor in possession debt.
B)they can delay pre-bankruptcy interest payments.
C)the lack of information about the length and magnitude of the cash flow problem favors
Equityholders.
D)the tax treatment of the cancellation of indebtedness is better.
E)All of the above.

Question 10

If a firm has a equity based insolvency in both book and market value terms and liquidates:

A)the payoff will not be 100% to all investors.
B)the unsecured creditors are likely to get less than full value.
C)the equityholders typically should receive nothing.
D)the administration expenses are likely to get full value.
E)All of the above.

Question 11

Most firms in financial distress do not fail and cease to exist.Many firms can actually benefit from distress by:

A)Forcing a firm to re-evaluate their core operations to retain.
B)Realigning their capital structure to reduce interest costs.
C)Enter Insolvency and liquidate the firm.
D)Both A and B.
E)Both A and C.

Question 12

Financial restructuring can occur as:

A)A private workout.
B)An employee buy-out.
C)A bankruptcy reorganization.
D)Both A and C.
E)Both B and C.

Question 13

The absolute priority rule:

A)is set to ensure senior claims are paid first.
B)is the priority rule in liquidations.
C)distributes proceeds of secured assets sales to the secured creditors first and the
Remainder to the unsecured.
D)is significant when the secured property is liquidated and cash is insufficient to cover the
Amount owed, the remaining liquidated value is divided among secured and unsecured
Creditors.
E)All of the above.

Question 14

Many corporations choose Reorganisation bankruptcy proceedings voluntarily because the management can:

A)take up to 120 days to file a reorganization plan.
B)continue to run the business.
C)reorganize if the required fractions of creditors approve of the plan and it is confirmed
Reorganization takes place.
D)have the advantage of not losing the tax carry-forwards.
E)All of the above.

Question 15

Flow-based insolvency is:

A)A balance sheet measurement.
B)A negative equity position.
C)When operating cash flow is insufficient to meet current obligations.
D)Inability to pay one's debts.
E)Both C and D.

Question 16

Prepackaged bankruptcies are:

A)described as a combination of a private workout and a liquidation.
B)the easiest way to transfer wealth to the shareholders.
C)described as a combination of a completed private workout and the formal bankruptcy
filing.
D)the inexpensive way to transfer wealth to the shareholders.
E)None of the above.

Question 17

Equity-based insolvency is a:

A)Income statement measurement.
B)Balance sheet measurement.
C)Only a book value measurement.
D)Both A and C.
E)Both B and C.

Question 18

Financial distress may be more expensive if the:

A)Information about the permanency of shortfall is limited.
B)Firm has many different types of creditors and other investors.
C)Firm has never entered into bankruptcy before.
D)Both A and B.
E)Both B and C.

Question 19

Credit scoring models are used by lenders to:

A)Determine the borrowers capacity to pay.
B)Aid in the prediction of default or bankruptcy.
C)Determine the optimal debt equity ratio.
D)Both A and B.
E)Both A and C.

Question 20

Magic Mobile Homes is to be liquidated.All creditors, both secured and unsecured, are owed €2 million.Administrative costs of liquidation and wages payments are expected to be €500,000.A
Sale of assets is expected to bring €1.8 million after all costs and taxes.Secured creditors have a
Mortgage lien for €1,200,000 on the factory which will be liquidated for €900,000 out of the sale
Proceeds.The corporate tax rate is 34%.How much and what percentage of their claim will the
Unsecured creditors receive, in total?

A)€ 100,000; 12.50%
B)€ 290,909; 36.36%
C)€ 300,000; 37.50%.
D)€ 600,000; 75.00%
E)Not enough information to answer.

Question 21

Consider the following two statements: (i) The absolute priority rule states that senior equity holders are paid in full before other claimants.
(ii) To rule out liquidation, management of a firm can favor a corporate bankruptcy.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)Bankrupt firms cannot continue to do business.

Question 22

In the Z score model for private firms, the Z score is calculated as Z = 0.717 (Net Working Capital/Total Assets) + 0.847 (Accumulated Retained Earnings/Total Assets) +3.10 (EBIT/Total Assets) + 0.420 (Book Value of Equity/Total Liabilities) +0.998 (Sales/Total Assets).You are part owner of a private firm, which will start to make losses.To help pay the bills, the firm considers taking out an additional loan.What do you expect to happen to the firm's Z score?

Question 23

At a meeting about a firm that has come under distress, equity and debt holders have gathered. One of the persons present at the meeting urges all to remember that the firm's cash flow problems are just temporary.What is this person most likely to be, an equity or a debt holder, and why?

Question 24

In the Z score model for private firms, the Z score is calculated as Z = 0.717 (Net Working Capital/Total Assets) + 0.847 (Accumulated Retained Earnings/Total Assets) +3.10 (EBIT/Total Assets) + 0.420 (Book Value of Equity/Total Liabilities) +0.998 (Sales/Total Assets).You are part owner of a private firm.The firm currently has a Z score of 2.60.You and the other owners have taken measures that will double the firm's profitability to 20% in the next year.What will the firm's new Z score say about its survival chances?

Question 25

In the Z score model for private firms, the Z score is calculated as Z = 0.717 (Net Working Capital/Total Assets) + 0.847 (Accumulated Retained Earnings/Total Assets) +3.10 (EBIT/Total Assets) + 0.420 (Book Value of Equity/Total Liabilities) +0.998 (Sales/Total Assets).You are part owner of a private firm, which currently suffers from major liquidity problems.How and where is this going to affect the firm's Z score?

Question 26

In the Z score model for private firms, the Z score is calculated as Z = 0.717 (Net Working Capital/Total Assets) + 0.847 (Accumulated Retained Earnings/Total Assets) +3.10 (EBIT/Total Assets) + 0.420 (Book Value of Equity/Total Liabilities) +0.998 (Sales/Total Assets).You are part owner of a private firm.The firm currently has a Z score of 2.60.You find out that you have in fact made a major mistake in the valuation of your assets, which turns out to be 20% higher than you previously had thought.Leverage remains unaffected, however, with equal shares debt and equity.Should you be worried about your firm's survival chances? Why or why not?

Question 27

The Here Today Corporation has applied to your bank for a loan. You have their financial statements and the revised Z-score model of:
Z = 6.56 (Net Working Capital/Total Assets) + 3.26 (Accumulated Retained Earnings/Total Assets) +6.72 (EBIT/Total Assets) + 1.05 (Book Value of Equity/Total Liabilities) where: Z < 1.23 predicts bankruptcy. A Z score between 1.23 and 2.90 indicates gray area. A Z score greater than 2.90 indicates no bankruptcy. From the financial statements you gathered net working capital of €237,500; accumulated retained earnings of €120,000; book value of equity of €950,000; total assets of €4,750,000; EBIT of €261,250; and total liabilities of €3,800,000. Should the bank lend to Here Today?

Question 28

The management of Magic Mobile Homes has proposed to reorganize the firm.The proposal is based on a going-concern value of €2 million.The proposed financial structure is €750,000 in new
Mortgage debt, €250,000 in subordinated debt and €1,000,000 in new equity.All creditors, both
Secured and unsecured, are owed €2.5 million euros.Secured creditors have a mortgage lien for
€1,500,000 on the factory.The corporate tax rate is 34%.What will the equityholders receive if they
Had 5 million shares with a par value of €0.50 each?

A)€0
B)€35,714
C)€583,333
D)€1,000,000
E)None of the above.

Question 29

Consider the following two statements: (i) in the UK, the most popular way to resolve financial distress has been asset contraction.
(ii) In the UK, the least popular way to resolve financial distress has been asset expansion.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)Bankrupt firms cannot continue to do business.

Question 30

Consider the following two statements: (i) in the U.S., approximately half of the financial restructurings have been done via private workouts.
(ii) in the U.S., approximately 70% of large public firms that have filed for bankruptcy continue to do
Business.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)Bankrupt firms cannot continue to do business.

Question 31

The US legislation on bankruptcy has benefits and drawbacks, when compared to similar legislation in most other countries.Describe the most important benefit and the most important drawback.

Question 32

The management of Magic Mobile Homes has proposed to reorganize the firm.The proposal is based on a going-concern value of €2 million.The proposed financial structure is €750,000 in new
Mortgage debt, €250,000 in subordinated debt and €1,000,000 in new equity.All creditors, both
Secured and unsecured, are owed €2.5 million euros.Secured creditors have a mortgage lien for
€1,500,000 on the factory.The corporate tax rate is 34%.How much should the secured creditors
Receive?

A)€1,000,000
B)€1,250,000
C)€1,333,333
D)€1,500,000
E)None of the above.

Question 33

The Steel Pony Company, a maker of all-terrain recreational vehicles, is having financial difficulties due to high interest payments. The estimated "going concern" value if Steel Pony is € 4.0 million. The senior debt claim is on all fixed assets. The balance sheet of the firm is as shown:

If Steel Pony decides to file for formal bankruptcy and expects to sell the firm for the "going concern" value and pay administrative fees which amounts to 5% of the total going concern value, determine the distribution of the proceeds under the rules of absolute priority.

Question 34

Consider the following two statements: (i) firms that emerge from private workouts experience share price increases that are much greater
Than those for firms emerging from formal bankruptcies.
(ii) the direct costs of formal bankruptcies are much less than the costs of private workouts.

A)(i) is correct and (ii) is incorrect.
B)(ii) is correct and (i) is incorrect.
C)Both (i) and (ii) are correct.
D)Both (i) and (ii) are incorrect.
E)Bankrupt firms cannot continue to do business.

Question 35

Magic Mobile Homes is to be liquidated.All creditors, both secured and unsecured, are owed €2 million.Administrative costs of liquidation and wages payments are expected to be €500,000.A
Sale of assets is expected to bring €1.8 million after all costs and taxes.Secured creditors have a
Mortgage lien for €1,200,000 on the factory which will be liquidated for €900,000 out of the sale
Proceeds.The corporate tax rate is 34%.How much and what percentage of their claim will the
Secured creditors receive, in total?

A)€ 900,000; 75%
B)€ 981,818; 81.82%
C)€1,009,091; 84.1%
D)€1,200,000; 100%
E)Not enough information to answer.

Question 36

The management of Magic Mobile Homes has proposed to reorganize the firm.The proposal is based on a going-concern value of €2 million.The proposed financial structure is €750,000 in new
Mortgage debt, €250,000 in subordinated debt and €1,000,000 in new equity.All creditors, both
Secured and unsecured, are owed €2.5 million euros.Secured creditors have a mortgage lien for
€1,500,000 on the factory.The corporate tax rate is 34%.How much should the unsecured
Creditors receive?

A)€ 500,000
B)€ 667,000
C)€ 750,000
D)€1,000,000
E)None of the above.