Question

1. Suppose Teflon Corp. has a market value of $200 million as a going concern. It currently has outstanding debt of $240 million. If the company declares bankruptcy, bankruptcy costs will total $40 million. As an alternative to bankruptcy, the company’s board proposes to exchange a portion of the company’s equity for the existing debt. What percentage of the company’s equity should the creditors demand in this situation?

Answer 1

Suppose Teflon Corp. has a market value of $200 million as a going concern. It currently has outstanding debt of $240 million. If the company declares bankruptcy, bankruptcy costs will total $40 million. As an alternative to bankruptcy, the company’s board proposes to exchange a portion of the company’s equity for the existing debt. What percentage of the company’s equity should the creditors demand in this situation?

• Proceeds for the creditors if bankruptcy option is opted

Particulars	Amount (Million $)
Maket Value of Company	200
Less: Bankruptcy Cost	(40)
Net proceeds	160

If the bankruptcy option is opted, the net proceeds will be $ 160 Millions.

• Equity to be demanded should atleast be equal to bankruptcy option. Thus,

Equity to be demanded in lieu of bankruptcy = Net proceeds in option 1 / Market Value of company

                                                                 = 160 / 200

                                                                 = 80%

Thus creditors should at least take 80% equity of the company to remain par with bankruptcy option.

Hope you understand the solution.