Introduction to Corporate Finance

22: Insolvency and Financial Distress

TABLE 22.5 PRO RATA DISTRIBUTION OF FUNDS AMONG THE UNSECURED CREDITORS OF OXFORD COMPANY

Unsecured creditors’ claims Amount Settlement at 32%a After subordination

Unpaid balance on second mortgage $ 400,000b $ 129,032 $ 129,032

Accounts payable 200,000 64,516 64,516

Notes payable – bank 1,500,000 483,871 806,452

Subordinated debentures 1,000,000 322,581 0

Totals $3,100,000 $1,000, 000 $1,000,000

a The 32% rate is calculated by dividing the $1 million available for the unsecured creditors by the $3.1 million owed the unsecured creditors. Each is

entitled to a pro rata share.

b This figure represents the difference between the $800,000 second mortgage and the $400,000 payment on the second mortgage from the proceeds

from the sale of the collateral remaining after satisfying the first mortgage.

6 What is the significance of subordinating a claim if a company is liquidated?

7 Why is payment of the expenses of administering the insolvency proceeding given the highest

priority?

CONCEPT REVIEW QUESTIONS 22-3

22-4 PREDICTING INSOLVENCY

Many analysts attempt to predict the occurrence of insolvency using a tool like Altman’s Z score, named

after Professor Edward Altman of New York University.

The Z-score is the output of a quantitative model that uses a blend of traditional financial ratios and a

statistical technique known as multiple discriminant analysis. In some tests, the Z-score has been found

to be about 90% accurate in forecasting insolvency one year in the future and about 80% accurate in

forecasting it two years in the future. The model was estimated for US manufacturing companies for

recent times up to 2000 as follows:

Z = 1.2(X 1 ) + 1.4(X 2 ) + 3.3(X 3 ) + 0.6(X 4 ) + 1.0(X 5 )

where

■ X 1 = Working capital ÷ Total assets

■ X 2 = Retained earnings ÷ Total assets

■ X 3 = Earnings before interest and taxes ÷ Total assets

■ X 4 = Market value of equity ÷ Book value of total liabilities

■ X 5 = Sales ÷ Total assets

The guidelines for classifying businesses are: Z-score less than or equal to 1.8, high probability

of insolvency; Z-score between 1.81 and 2.99, unsure; and Z-score of 3.0 or higher, insolvency

unlikely.

LO 22.4
Z-score
The product of a quantitative
model for forecasting
insolvency that uses a
blend of traditional financial
ratios and a statistical
technique known as multiple
discriminant analysis. In
some tests, the Z-score
has been found to be about
90% accurate in forecasting
insolvency one year in
the future and about 80%
accurate in forecasting it two
years in the future

Your company is considering

lending money to a new

customer. What factors might

you consider in determining

whether or not to lend to this

customer?

thinking cap

question