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

A firm has debt with face value 100 and plans a distressed exchange. Existing creditors would receive, in a workout, 60 in value. In formal bankruptcy, the estimated recovery is 50 of value after direct costs. Equity holders will receive nothing in bankruptcy but would retain an option value of 5 in a workout. Ignoring other factors, which statement best describes the outcome?

A workout is mutually beneficial. Creditors receive 60 instead of 50 in bankruptcy and equity keeps 5 instead of nothing. The benchmark is the bankruptcy alternative, not face value, so both sides gain from avoiding the 10 of bankruptcy costs.

  1. ACreditors prefer bankruptcy because recovery is more certain
  2. BA workout is mutually beneficial since creditors get 60 versus 50 and equity retains 5 versus 0Correct
  3. CEquity holders will reject the workout because they receive less than face value
  4. DA workout is infeasible because creditors receive less than 100

Explanation

The relevant comparison is the alternative to the workout, not face value. Creditors receive 60 versus 50 in bankruptcy, and equity gets 5 versus 0, so both parties are better off, a Pareto improvement of the 10 saved in costs.

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