Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

17. Financial Leverage and
    Capital Structure Policy

(^622) © The McGraw−Hill
Companies, 2002
1.Business failure.This term is usually used to refer to a situation in which a business
has terminated with a loss to creditors, but even an all-equity firm can fail.
2.Legal bankruptcy. Firms or creditors bring petitions to a federal court for
bankruptcy. Bankruptcyis a legal proceeding for liquidating or reorganizing a
business.
3.Technical insolvency. Technical insolvency occurs when a firm is unable to meet its
financial obligations.
4.Accounting insolvency.Firms with negative net worth are insolvent on the books.
This happens when the total book liabilities exceed the book value of the total
assets.
We now very briefly discuss some of the terms and more relevant issues associated
with bankruptcy and financial distress.
Liquidation and Reorganization
Firms that cannot or choose not to make contractually required payments to creditors
have two basic options: liquidation or reorganization. Liquidationmeans termination
of the firm as a going concern, and it involves selling off the assets of the firm. The pro-
ceeds, net of selling costs, are distributed to creditors in order of established priority.
Reorganizationis the option of keeping the firm a going concern; it often involves is-
suing new securities to replace old securities. Liquidation or reorganization is the result
of a bankruptcy proceeding. Which occurs depends on whether the firm is worth more
“dead or alive.”
Bankruptcy Liquidation Chapter 7 of the Federal Bankruptcy Reform Act of 1978
deals with “straight” liquidation. The following sequence of events is typical:

1. A petition is filed in a federal court. Corporations may file a voluntary petition, or
   involuntary petitions may be filed against the corporation by several of its creditors.


2. A trustee-in-bankruptcy is elected by the creditors to take over the assets of the
   debtor corporation. The trustee will attempt to liquidate the assets.


3. When the assets are liquidated, after payment of the bankruptcy administration
   costs, the proceeds are distributed among the creditors.


4. If any proceeds remain, after expenses and payments to creditors, they are
   distributed to the shareholders.
   The distribution of the proceeds of the liquidation occurs according to the following
   priority list:


5. Administrative expenses associated with the bankruptcy


6. Other expenses arising after the filing of an involuntary bankruptcy petition but
   before the appointment of a trustee


7. Wages, salaries, and commissions


8. Contributions to employee benefit plans


9. Consumer claims


10. Government tax claims


11. Payment to unsecured creditors


12. Payment to preferred stockholders


13. Payment to common stockholders

CHAPTER 17 Financial Leverage and Capital Structure Policy 595

bankruptcy

A legal proceeding for

liquidating or

reorganizing a business.

The SEC has a good

overview of the

bankruptcy process in its

“online publications”

section: http://www.sec.gov.

liquidation

Termination of the firm

as a going concern.

reorganization

Financial restructuring of

a failing firm to attempt

to continue operations

as a going concern.