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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A firm has a 30% probability of falling into distress next year. If distress occurs, the firm expects direct and indirect costs equal to 12% of current firm value, which is USD 500 million. The firm's marginal tax rate is 25%, and the present value of the interest tax shield from its current debt is USD 20 million. Ignoring discounting of the distress costs, what is the net value effect of the current debt versus an all-equity structure?

The net effect is a gain of USD 2 million. Expected distress costs equal 30% times 12% times USD 500 million, or USD 18 million, which is subtracted from the USD 20 million tax shield benefit, leaving a small positive net value from the debt.

  1. ANet gain of USD 2 millionCorrect
  2. BNet loss of USD 2 million
  3. CNet gain of USD 38 million
  4. DNet gain of USD 20 million

Explanation

Expected distress cost = 0.30 × 0.12 × 500 = USD 18 million. Net effect = tax shield 20 − expected cost 18 = +USD 2 million. Choosing a loss of 2 reverses the sign. Using 38 adds the cost instead of subtracting it.

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