Introduction to Corporate Finance

22: Insolvency and Financial Distress

SUMMARY

■ Financial distress refers to the condition

that a company’s cash flows are insufficient

to pay its current obligations.

■ Insolvency refers to the legal process that

companies go through to resolve financial

distress. It gives the debtor company (and

its management) an opportunity to

renegotiate with creditors.

■ Valuation disputes are common in

insolvency, since each party has

incentive for the company’s assets to

be valued in a way that is favourable to its

own priority status.

■ Alternatives to the voluntary administration

are liquidation and receivership.

■ Quantitative models have been developed

to predict the likelihood that an individual

company may become insolvent. The best-

known model for predicting insolvency

calculates the company’s Z-score, which

results from application of a statistical

technique to traditional financial ratios.

KEY TERMS

administrator, 765

business failure, 763

Corporations Act 2001, 763

deed of company arrangement,

764

financial distress, 763

insolvency, 763

insolvent, 763

liquidation, 769

receivership, 774

trustee, 772

voluntary administration, 764

Z-score, 777

SELF-TEST PROBLEMS

Answers to Self-test problems and the Concept review questions throughout the chapter appear on

CourseMate with SmartFinance Tools at http://login.cengagebrain.com.

ST22-1 A company has $8 million in funds to distribute to its unsecured creditors. Three possible sets of

unsecured creditor claims are presented. Calculate the settlement, if any, to be received by each

creditor in each case shown in the following table.

Unsecured creditors’ claims Case I Case II Case III

Unpaid balance of second mortgage $ 2,000,000 $ 2,500,000 $ 5,000,000

Accounts payable 2,500,000 3,000,000 4,000,000

Notes payable – bank 3,500,000 3,500,000 1,500,000

Unsecured bonds 4,000,000 5,000,000 5,500,000

Total $12,000,000 $14,000,000 $16,000,000

ST22-2 Oxygen Filtration Systems recently failed, and will be liquidated by a court-appointed

administrator, who will charge $500,000 for his services. The pre-liquidation balance sheet

follows. Assume that the administrator liquidates the assets for $10.2 million, with $5.8 million

coming from the sale of current assets and $4.4 million coming from fixed assets. Also assume

that the unsecured bonds are subordinate to the notes payable. Prepare a table indicating the

amount to be distributed to each claimant. Do the company’s owners receive any funds?

LO 22.1

LO 22.2

LO 22.3

LO 22.4