Liquidations in bankruptcy

When a business is worth more if its assets are sold than if it continues to operate, then the business is liquidated, and the proceeds from the sale are used to satisfy any outstanding debt.

Liquidation occurs when businesses file for bankruptcy under Chapter 7 of the Federal Bankruptcy Reform Act. This act provides for an equitable distribution of the debtors assets among the creditors. The distribution of assets is governed by a certain priority of claims.

Which of the following claimants has the highest priority according to Chapter 7?

Legal and administrative fees to operate the bankrupt firm

State taxes due

Unsecured claims for customer deposits

Wages due before three months of filing

Blue Pencil Publishing has been in financial distress for the past three years. The companys reorganization plans were rejected, and the bankruptcy court is forcing Blue Pencil Publishing to liquidate its assets and settle creditor claims.

The court appointed the trustee with an estimated expense budget of $843,750. Subordinated debentures are subordinated only to the notes payable.

Blue Pencil Publishing Balance Sheet (Thousands of dollars)
Current assets	$5,625	Accounts payable	$1,125
Net fixed assets	5,625	Notes payable	2,250
		Subordinated debentures	2,250
		Total debt	5,625
		Common equity	5,625
Total assets	$11,250	Total liabilities and equity	$11,250

The trustee has arranged the sale of Blue Pencil Publishings assets and estimates to receive $7.50 million in proceeds from the liquidation.

Proceeds from the liquidation will be used to settle Blue Pencil Publishings liabilities. Based on your understanding of distribution of assets to various claimants, how much will common stockholders receive (if they receive anything at all) when Blue Pencil Publishing is liquidated?

$1,875,000

$1,031,250

$1,134,375

$2,156,250

The bankruptcy courts and the company have discretion in how they elect to handle a failing firm. Just as the decision to reorganize or liquidate the firm depends on the relationship between its going concern and its liquidation values, the significance and competitiveness of the industry in which the failing firm operates also affects the courts decision. If Blue Pencil Publishing were a public utility company or a railroad service company instead of an industrial corporation, the bankruptcy courts would likely push for

reorganization.

liquidation.