Question

1. Explain why in general bankruptcy financing can benefit the firm’s existing lenders, even though the new debt takes priority over the firm’s existing debt.

2. Explain why in general it is important to existing lenders that the bankruptcy financing loans have financial covenants that limit the ability of the firm to use the cash to try to turn around the business.

Answer 1

1. Bankruptcy financing is a type of funding which is raised so that the company is able to continue its operations until it goes through the bankruptcy process. It is beneficial for the existing lender because if the company assets are operational then there is a high probability that the assets will be sold close to its fair value and debtors will be able to recover maximum of their loan value but if the assets are not being used and they have become defunct then the value at which the assets will be sold is at very low and the debtors will also be at loss.

2. The bankruptcy loan covenants protect the debtors by forcing the management to use the cash for the operational purposes. When the company is going through the bankruptcy then there is high probability that even senior management might like to divert the cash to some new venture or for new capital expenditure, or they might would want to raise further debt and divert the funds to other enterprise. To avoid these kind of scenarios covenants are important and to protect the interest of the existing lenders.