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

A distressed firm has 60 of senior secured bank debt and 40 of unsecured bonds. Going-concern value is 70; liquidation value is 45. Banks propose an out-of-court deal: they keep 60 of claims but extend maturity, while bondholders exchange 40 of bonds for 100% of equity. Under strict absolute priority in liquidation, what is the bondholders' recovery, and what does this imply about their incentive in the workout?

Bondholders recover zero in liquidation because 45 is below the 60 senior claim. In the workout, equity is worth about 70 minus 60, or 10, which is better than zero, so they have a rational incentive to accept the equity exchange.

  1. A0 in liquidation; they would still accept equity worth 10 since it beats zeroCorrect
  2. B5 in liquidation; they would reject any equity offer
  3. C45 in liquidation; they are indifferent to the offer
  4. D0 in liquidation; they would reject because equity is junior to debt

Explanation

Liquidation value of 45 is less than the senior claim of 60, so the banks absorb all of it and bondholders get 0. Under the deal, equity is worth 70 - 60 = 10 if the banks are paid in full at par, which beats 0. Bondholders therefore have an incentive to accept, though holdout dynamics still matter.

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