Financial distress and trade-off

Financial distress and trade-off

1. 1. Which of the following are INDIRECT costs of financial distress (vs direct)?

   Customer defections to competitorsAsset fire sales below fair valueManager time absorbed by creditor negotiationsLegal and bankruptcy attorney fees

2. 2. Trade-off theory of capital structure says the optimal D/V is where:

   Tax shield equals zeroMarginal tax-shield benefit equals marginal expected distress costCost of debt equals cost of equityBeta equals one

3. 3. Why do knowledge-intensive firms (tech, pharma) typically carry less debt than utilities?

   Lower tax ratesDistress costs for intangible-heavy firms are much higher — losing key talent and customers permanently destroys IP value that has no replacement costRegulators forbid itTheir cost of debt is higher

4. 4. Debt overhang: a firm has $100M existing debt, asset value $80M, and could fund a new project requiring $20M new equity that produces $30M PV. Why might equity holders refuse to fund it?

   Because the project has negative NPVBecause the $30M of new value goes to debt holders first; equity holders pay $20M to get only ~$10M after debt is repaidBecause the project's risk is too highBecause management lacks confidence