Advanced Financial Management · Business re-organisation

Reconstruction Scheme Evaluation and Stakeholder Positions in AFM

Updated 11 October 2026 · Fact-checked

A reconstruction scheme restructures a distressed company's capital to avoid liquidation. To evaluate it, compare what each stakeholder receives under the scheme with what they would receive in liquidation, then test viability with forecast cash flows, a pro forma statement of financial position, gearing and interest cover. Creditors should only agree if they are better off.

Understand Reconstruction Scheme Evaluation and Stakeholder Positions

A company in financial distress cannot pay its debts or is heading that way. The alternatives are liquidation or a reconstruction scheme. In a scheme, the company changes its capital structure: debt may be written down, swapped for shares, or have its terms extended. New money may be raised. The aim is to keep the business running.

A scheme only works if the stakeholders agree to it. Each party asks one question: am I better off than in liquidation? Liquidation is the fallback, so it sets the minimum each party will accept. If a creditor would get 50c per $1 in liquidation, offering 40c plus a vague promise will fail.

So the first job is a liquidation baseline. Start with the cash the assets would realise, net of liquidation costs. Pay secured creditors from their security first. Then share what is left among the unsecured creditors in proportion to their claims. Shareholders are paid last and usually get nothing.

The second job is to compare. For each party, put the scheme value (cash, new debt, new shares, at realistic values) next to the liquidation value. Parties who gain should accept. Parties who lose will block the scheme unless something else compensates them. Note that the existing shareholders often give up a lot of control, but they get nothing in liquidation, so they accept.

The third job is viability. A fair scheme that leaves the company unable to service its debt just delays failure. Forecast post-scheme cash flows, build a pro forma statement of financial position, and check gearing, interest cover and liquidity. Finally, comment on the commercial risks: will suppliers keep trading, will new investors put in cash, and are the forecasts realistic?

Key rules to remember

Secured creditor recovery in liquidation: Recovery = lower of (claim, value of security realised); Any surplus on the security joins the pool for unsecured creditors. Any shortfall becomes an unsecured claim.
Recovery per $1 for unsecured creditors: Cash available to unsecured ÷ total unsecured claims; Cash available = net realisation proceeds less liquidation costs less amounts paid to secured creditors from their security. Include any shortfall of secured creditors in the claims.
Fairness test for each stakeholder: Scheme value ≥ liquidation value; Scheme value = cash + market value of new debt and shares received. Use realistic values for new securities, not nominal amounts.
Gain on write-off: Gain = old liability − new consideration (cash + new debt + new shares at nominal); Taken to reserves in the pro forma statement of financial position.
Gearing: Debt ÷ equity, or debt ÷ (debt + equity); State which definition you use. Use market values if given, otherwise book values and say so.
Interest cover: Operating profit before interest ÷ interest expense; Compare before and after the scheme. Use forecast profit, not past profit.

How to solve Reconstruction Scheme Evaluation and Stakeholder Positions questions

Use this order for any reconstruction question. It matches how marks are given: baseline, comparison, viability, then advice.

1Read the requirement. Note which parties are named and whether you must produce a pro forma statement of financial position, gearing or advice.
2Build the liquidation baseline. Realise assets net of costs, pay secured creditors from their security, then divide the remainder among unsecured claims. Show recovery per $1 for each class.
3Work out what each stakeholder receives under the proposed scheme: cash, new loan notes, new shares, deferred payments. Value new securities realistically.
4Compare scheme versus liquidation for each party in a short table or list. State clearly who is better off, who is worse off, and by how much.
5Prepare the pro forma statement of financial position. Show write-offs, share issues, new cash and the resulting reserves. Check that assets equal liabilities plus equity.
6Test viability. Calculate gearing and interest cover after the scheme, and review forecast cash flows and liquidity against the new debt service.
7Conclude. Say whether each party should accept, what might need to change (for example more equity for creditors), and the key risks.
8Add professional skills: keep the answer in the form asked for (report or memo), be sceptical about forecasts, and give a clear recommendation.

Quickest way: Liquidation-first comparison table

When to use it: Use when time is short and the question gives clear liquidation values and scheme terms.

Draw one table with columns: Party, Claim, Liquidation recovery, Scheme value, Better or worse off.
Fill the liquidation column first, using secured claims, then pence per $1 for unsecured.
Fill the scheme column with cash plus new securities at the values the question gives.
Mark each row better or worse and write one line of comment under the table.
Do the pro forma statement of financial position only for the lines that change. Check it balances.
Calculate one gearing figure and one interest cover figure, then write a short viability conclusion.

Common mistakes in Reconstruction Scheme Evaluation and Stakeholder Positions

Ignoring liquidation costs, or forgetting that secured creditors are paid first.
Students rush to the unsecured split and treat all creditors alike.
Fix: Always deduct costs, pay secured creditors from their security first, and only then divide the rest. Add any security shortfall to unsecured claims.
Valuing new shares or loan notes issued to creditors at nominal value only.
Nominal values are easy to read from the question.
Fix: Use the market or estimated value if given. Comment that nominal value can overstate what creditors really receive.
Treating existing shareholders as losing out compared with liquidation.
Students compare the new holding with the old holding, not with liquidation.
Fix: Compare with liquidation, where shareholders usually get nothing. A smaller stake in a surviving company is usually an improvement.
Pro forma statement of financial position that does not balance.
The gain on write-off is forgotten, or new cash is not added to assets.
Fix: Record each scheme step as a double entry. Gains on write-off go to reserves. Check total assets equal liabilities plus equity.
Stopping after the fairness test and ignoring viability.
The numbers feel complete once the comparison is done.
Fix: Always add gearing, interest cover and cash flow comments. A scheme that is fair but not viable should be rejected or reworked.
Giving a list of calculations with no advice.
Students think the numbers are the answer.
Fix: End with a recommendation for each stakeholder group, and say what must change if a party would reject the scheme.

Worked examples

Example 1

Delta Co is in distress. Net liquidation proceeds, after costs, would be $10m. Bank loan of $5m is secured on property that would realise $6m of that $10m. Unsecured claims are trade payables $6m and loan notes $4m. Under the proposed scheme the bank is unchanged, trade payables receive $4.2m in full settlement, loan note holders swap their $4m for new loan notes with a value of $3m, and shareholders keep the business. Test whether each party is better off than in liquidation.

Show the solution

Liquidation: bank is secured and gets its full $5m from the property. The property surplus of $1m stays in the pool.
Cash left for unsecured creditors = $10m − $5m = $5m.
Unsecured claims = $6m + $4m = $10m. Recovery = $5m ÷ $10m = 50c per $1.
Trade payables in liquidation: $6m × 50% = $3m. Loan note holders: $4m × 50% = $2m. Shareholders: nil.
Scheme: bank receives $5m of claim unchanged, so it is no worse off. Trade payables receive $4.2m versus $3m, a gain of $1.2m. Loan note holders receive $3m versus $2m, a gain of $1m.
Shareholders: nil in liquidation, so keeping a stake in a continuing business is better.
Conclusion: all parties are at least as well off, so they have a rational reason to agree.

Answer: Liquidation recovery is 50c per $1 for unsecured creditors. Trade payables improve from $3m to $4.2m and loan note holders from $2m to $3m. The bank is paid in full either way and shareholders get more than nil. The scheme passes the fairness test, subject to the viability test.

Example 2

Epsilon Co's statement of financial position before reconstruction: non-current assets $12m, current assets $6m (total $18m). Bank loan $6m at 8%, loan notes $5m at 9%, trade payables $6m, share capital $4m ($1 shares), reserves (deficit) $(3)m. Proposed scheme: (1) loan notes of $5m are exchanged for $2m of new 7% loan notes plus 2m new $1 shares, with the remainder written off; (2) trade payables are reduced by 25%; (3) a rights issue of 2m $1 shares at $1 each raises cash. Forecast operating profit before interest after the scheme is $1.86m. Prepare the pro forma statement of financial position and calculate gearing (debt ÷ equity, book values) and interest cover before and after, assuming the same operating profit before.

Show the solution

Loan notes: $5m − $2m new loan notes − $2m shares at nominal = $1m written off. Gain $1m.
Trade payables: $6m × 25% = $1.5m written off. New payables = $4.5m. Gain $1.5m.
Rights issue: 2m shares × $1 = $2m cash and $2m share capital.
Assets: current assets $6m + $2m = $8m. Non-current assets $12m. Total $20m.
Liabilities: bank loan $6m, new loan notes $2m, trade payables $4.5m. Total $12.5m.
Share capital: $4m + $2m (swap) + $2m (rights) = $8m. Reserves: $(3)m + $1m + $1.5m = $(0.5)m. Equity = $7.5m.
Check: liabilities $12.5m + equity $7.5m = $20m. This equals total assets.
Gearing after: debt = $6m + $2m = $8m. $8m ÷ $7.5m = 106.7%.
Interest after: bank $6m × 8% = $0.48m, loan notes $2m × 7% = $0.14m. Total $0.62m. Cover = $1.86m ÷ $0.62m = 3.0 times.
Interest before: $0.48m + ($5m × 9% = $0.45m) = $0.93m. Cover = $1.86m ÷ $0.93m = 2.0 times.
Before gearing: debt = $11m, equity = $1m, so gearing = 1,100%. The scheme reduces gearing sharply.

Answer: Pro forma: non-current assets $12m, current assets $8m, total $20m. Bank loan $6m, new loan notes $2m, trade payables $4.5m, share capital $8m, reserves $(0.5)m. Gearing falls from 1,100% to 106.7%. Interest cover rises from 2.0 times to 3.0 times. The structure is more sustainable, though gearing is still high and depends on the profit forecast being achieved.

Exam tips

Always show the liquidation baseline with workings. Marks are given for the method even if one number is wrong.
Write one line of comment per stakeholder: better or worse off than liquidation, and whether they would likely accept.
In the pro forma, show each adjustment in its own column or line so the marker can follow it. Check that it balances before moving on.
Question the forecasts. Say what could go wrong (lost customers, tight cash, optimistic profit) and how sensitive interest cover is to it.
Finish with a clear recommendation in the format requested, such as a report to the board or a briefing for creditors.

Practice questions from Business re-organisation

Reconstruction Scheme Evaluation and Stakeholder Positions: frequently asked questions

Why do we compare each stakeholder with liquidation?

Liquidation is what happens if the scheme fails, so it is the fallback each party will judge the offer against. A rational creditor accepts a scheme only if it gives at least as much as liquidation. This sets the minimum terms the company must offer.

How do I decide if a reconstruction scheme is viable?

Look at forecast cash flows, gearing and interest cover after the scheme. Check that the company can pay its debt interest and repayments from the cash it generates. Also consider liquidity, supplier confidence and whether the forecasts are realistic.

Do I always need a pro forma statement of financial position?

Only if the question asks for it or you need it to calculate gearing. When asked, show the write-offs, new share issues and new cash clearly, and make sure it balances. Where the question does not ask, a short list of adjusted figures may be enough.

What if one stakeholder is worse off under the scheme than in liquidation?

That party is likely to reject it. Say so, and suggest changes such as more shares, higher cash payment or better security for that group. Explain how this affects other parties and the viability of the plan.