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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A company has assets with a market value of USD 500 million and debt with face value of USD 450 million. Over the next year, asset value is expected to fall to USD 400 million in a downturn scenario. The firm also has USD 60 million of debt maturing, USD 20 million cash and no committed credit lines. Which conclusion is most accurate for the downturn scenario?

In the downturn, assets of USD 400 million against USD 450 million of debt give negative equity of USD 50 million, so the firm is insolvent on a balance-sheet basis. Maturing debt of USD 60 million less USD 20 million cash leaves a USD 40 million liquidity shortfall.

  1. AThe firm is both balance-sheet insolvent (equity of negative USD 50 million) and faces a liquidity shortfall of USD 40 million on maturing debtCorrect
  2. BThe firm is solvent because equity is positive USD 50 million, and there is no liquidity shortfall
  3. CThe firm is insolvent with equity of negative USD 10 million and a liquidity shortfall of USD 60 million
  4. DThe firm is solvent with equity of USD 400 million and a liquidity shortfall of USD 40 million

Explanation

Downturn equity = 400 - 450 = -50 million, so balance-sheet insolvent. Liquidity shortfall = 60 maturing - 20 cash = 40 million with no credit lines. The other options miscalculate equity, ignore cash, or ignore debt.

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