Explore BrainMass

Explore BrainMass

    Financial Distress and Bankruptcy

    Because interest payments on debt are tax-deductible, debt provides a tax benefit over equity when used to finance a firm. So what stops a firm from having a capital structure that is mostly debt? In a downturn, a firm financed with equity will stay solvent because the required returns that shareholders expect do not have to be paid out in cash. However, interest payments on debt are fixed - if the firm’s cash flows drop, it still must meet all of its current obligations. If too much of the firm is financed through debt, the firm may have trouble always meeting its interest payments and accounts payable when they become due. In this situation, tax savings from the use of debt are offset by what we call financial distress costs.

    Financial Distress
    Financial distress occurs when a firm does not have enough cash to meet its current obligations. During financial distress, a firm must make decisions such as selling off assets to cover its cash shortfall. These decisions may erode the value of the firm, and are choices the firm would not make without the presence of a cash shortfall.

    Firms may deal with financial distress in many ways. In addition to selling off assets, a firm may also reduce capital spending and research and development. The firm may also undergo a financial restructuring by negotiating with banks and other creditors, exchanging its equity for outstanding debt, and filing for bankruptcy protection or bankruptcy.

    Insolvency
    A firm will go into bankruptcy when it becomes insolvent, and a firm can be insolvent in two ways. Stock-based insolvency occurs when the firm’s debt is greater then the firm’s net assets. As a result, the firm will have a negative value for its equity. Flow-based insolvency occurs when the firm’s cash flows drop below its current contractual obligations.

    Bankruptcy
    When a firm files a voluntary petition for bankruptcy, or is forced into bankruptcy by an involuntary petition filed against it, a trustee-in-bankruptcy will be elected by the firm’s creditors to administrate the liquidation of the firm’s assets. Typically the claims against the firm will be paid out from the proceeds from selling the assets in the following order:

    1. Administrative and other expenses associated with bankruptcy
    2. Wages, salaries and commissions
    3. Municipal tax claims
    4. Rent
    5. Judgments against the firm such as claims from employee injuries
    6. Unsecured creditors*
    7. Preferred shareholders
    8. Common shareholders

    *Secured creditors are paid out of the proceeds from the sale of specific assets. Any amount owed to secured creditors once these specified assets are liquidated is lumped in with unsecured creditors.

    Conclusion
    Although the use of debt provides a tax benefit, when the level of debt becomes too high, financial distress costs offset these savings. Having a high level of debt makes the firm more risky, because interest payments are fixed, and must be paid even in a downturn. &As a result, most firms limit their use of debt.

     

    Photo by TAN Erica on Unsplash

    © BrainMass Inc. brainmass.com March 19, 2024, 5:54 am ad1c9bdddf

    BrainMass Solutions Available for Instant Download

    Decision Making in Companies

    Chimbell makes pickles and markets them in 500-gram tins. The full capacity of the plant is 120,000 tins per annum. The company charges $30 for each 500-gram tin. In the previous year, the company used only 50% of its capacity and the plant is presently operating at that level. Direct material $12 per tin Direct wages $3 per

    Bad debts: Bankruptcy and loans

    In 2010, Grace loaned her friend Paula $12,000 to invest in various stocks. Paula signed a note to repay the principal with interest. This past year, the stock market plunged, and Paula incurred large losses. In 2012, Paula declared personal bankruptcy and Grace was unable to collect any of her loan. Grace had no other gains or

    Federal and Local State Laws of Georgia Bankruptcy

    1 Scenario: Mark & Marilyn Married file a joint petition for Chapter 7 bankruptcy in Georgia, a case for which they were eligible under the "median income" and "means" tests. The Marrieds have lived in GA for more than 10 years. The Marrieds jointly own a house valued at $156,000 on which there is a $140,000 first mortgage bal

    Reasons for a Business to File for Bankruptcy

    There are many reasons why a business may file for bankruptcy. Discuss some of the reasons that would drive a business to file for bankruptcy. Limit the scope of your discussion to small businesses. What do you think is the most common reason? Be sure to provide some support to back up your position.

    Leadership Behavior and Motivation

    1. What are your thoughts on bankruptcy for small businesses - both good and bad? What are your perspectives of both the business owner and the creditor? 2. In what ways can government help or hinder small businesses development and success?

    Optimal Leverage Information

    What impact does asymmetric information have on the optimal level of leverage? Describe the implications of adverse selection and the lemons principle for equity issuance, as well as the empirical implications.

    Bankruptcy and Employee Claims

    Q-1: Sonia, a book dealer, has the following assets: a building worth $155,000, accounts receivable amounting to $32,500 due within the next three months, and $25,000 cash in the bank. Sonia's sole liability is a $300,000 note falling due tomorrow, and she is unable to pay it. Can Sonia be forced into involuntary bankruptcy unde

    Business Law & Management Ethics

    1. Why should a definition of law emphasize enforcement? 2. To what three factors do courts look for evidence of an implied partnership? 3. What is meant by corporate "double taxation"? Explain several ways in which double taxation may be avoided. 4. Which law, federal or state, governs bankruptcy proceedings? Under the Ba

    Calculate the optimal level of debt with and without financial distress.

    Progressive Home Health Care Inc. is a for-profit provider of home health care services in the Pacific Northwest. At present, it has EBIT of $2 million per year, no debt, and a market value of approximately $12 million. Although management is pleased with the good financial condition of Progressive, they are also concerned that

    Ohio and North Dakota Energy and Kodak Bankruptcy

    Please see the attached file. 1. Compare the Ohio energy boom of the 1880s to that of North Dakota today. 2. How is Kodak handling bankruptcy? I need to write answers about these two questions. The answers should be over one page.

    Bankruptcy as a Strategic Financial Tool

    What are the ethical implications of corporations such as United Airlines and General Motors which utilize bankruptcy as a strategic financial tool to reduce their pension and health benefit obligations?

    Bankruptcy and Student Loans

    Bankruptcy: Emily and the Enormous Amount of Student Loans Emily graduated from a very prestigious college and was in her second year of medical school. Emily's parents did not have the resources to help her pay for college. For the past six years, Emily survived using student loans and credit cards. Emily's latest student lo

    Involuntary Bankruptcy: Farming Case

    Because the loan is due in 90 days, Family First Farm is experiencing serious financial problems. Several creditors hinted that they might force Family First Farm into an involuntary bankruptcy if Family First Farm does not pay them. Family First Farm has been trying to prioritize their payments so that the creditors that are mo

    Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCA)

    1. Research BAPCPA. What are some of the primary goals of the legislation? Name at least two ways this law revised bankruptcy proceedings. Do you think these changes are for the better? Why or why not? 2. Emilio Tangen obtained a life insurance policy from Kausch Insurance Co. on the life of Jerrell Harwin, naming himself as

    Convertible Debt, Project Evaluation and Bankruptcy

    1. As a corporation what are the benefits and ramifications of using convertible debt to finance a publicly traded company? As an investor what are the benefits and ramifications of purchasing convertible debt in a publicly traded company? Are there any conflicts between the goals of the investor and the goals of the corporation

    Example of fairly priced securities

    When securities are fairly priced, why would the original shareholders of a firm pay the present value of bankruptcy and financial distress costs?

    Case Study

    Write a paper in which you: 1. Discuss how senior management's short-term focus on stock price in a publicly traded company can lead to unethical behavior. 2. American Airlines has historically manipulated its earning by deferring aircraft maintenance. Discuss how this behavior may be unethical to both its shareholders and cus

    McDaniel Mining Company

    At the time it defaulted on its interest payments and filed for bankruptcy, the McDaniel Mining Company had the following balance sheet (in thousands of dollars). The court, after trying unsuccessfully to reorganize the firm, decided that the only recourse was liquidation under Chapter 7. Sale of the fixed assets, which were ple

    Bankruptcy

    Please define bankruptcy. What are the various forms of bankruptcy that can be filed? Why do firms file bankruptcy? What are the issues and costs associated with bankruptcy?

    PV of Financial Distress Costs

    Use the information for the question(s) below. Provide step by step calculations for each. Big Blue Banana (BBB) is a clothing retailer with a current share price of $10.00 and with 25 million shares outstanding. Suppose that Big Blue Banana announces plans to lower its corporate taxes by borrowing $100 million and using the

    SOX: Destroying Evidence and Declaring Bankruptcy

    1.) One of the problems that Congress was concerned about was defendants who destroyed evidence might escape conviction via limitations in the coverage of existing statutes. Explain how the Sarbanes-Oxley Act (SOX) addresses this. 2.) People who commit securities fraud and are fined by state or federal authorities, ordered to

    Bankruptcy Law's - Are they Fair

    The recent changes in the bankruptcy laws have made it considerably more difficult for individuals and businesses to receive a Chapter 7 bankruptcy. The new law requires counseling and means testing and disallows persons who earn over the median state income to file for such a bankruptcy. Does this strike you as fair? What ratio

    Problems with compensation and benefit system

    Select an organization that either has or is experiencing challenges with its compensation and benefit system. The student will provided a brief historical view of the organization, an assessment of their current challenge, a review of other organizations who had a similar situation and the strategy they devised to address the