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Financial Distress


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AFM 371 Winter 2008
Chapter 31 - Financial Distress

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What Happens in Financial Distress?
Bankruptcy Liquidation and Reorganization
Current Issues in Financial Distress
Two Practice Problems From Chapter 16

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as we will see in Chapter 17, financial distress (and its associated costs) has a potentially large impact on capital structure decisions by firms a firm that defaults on a required payment may be forced to liquidate its assets however, more often a defaulting firm will restructure financial restructuring involves replacing old financial claims with new ones and takes place with either private workouts or legal bankruptcy

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What is Financial Distress?


financial distress is a situation where a firm’s operating cash flows are insufficient to meet its current obligations (and so the firm must take some kind of corrective action) financial distress may lead a firm to default on a contract, and it may involve financial restructuring between the firm, its creditors, and its shareholders in most cases, the firm is forced to take actions that it would not have taken if it had sufficient cash flow insolvency is a term which generally means an inability to repay debts stock-based insolvency occurs when the value of a firm’s assets is less than what is owed on its debt flow-based insolvency occurs when the firm’s cash flows are insufficient to cover contractually required payments

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Stock and Flow-Based Insolvency


Stock-Based Insolvency
Solvent Firm

Insolvent Firm




Negative Equity

Flow-Based Insolvency

Contractual obligations
Firm cash flow

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What Happens in Financial Distress? financial distress does not always result in the termination of the firm (is the

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