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A Question about Index-tracking Funds

I have a question about what happens in an index when a significant number of companies in an index go bankrupt. (Gee - guess what sector I might be talking about :-/) So, the value of the company's stock goes to zero, and the index falls accordingly. When a new entity gets picked to replace it, how does the value of that company get reinserted into the index?

For example, let's say there's a simple index that consists of A, B, C, and D, each stock sells for $10 and all the market caps are the same, so the index starts out at $100. A.B. and C stay at $10, and D goes bankrupt, so the index falls to $75. A new entity E is introduced whose stock is $10.

My guess is that the NAV of the index is redesigned such that the new entities, A, B, C, and E, split the $75 NAV at the time of D's bankruptcy. A, B, and C have a smaller representation in each share; each index investor's basis reflects the progress of all 5 entities including the demise of D.

Would this procedure be in the SIA for the various index funds and ETF's? I'll have to read through some.
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