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

A firm has a 40% chance of financial distress if it adopts a high-leverage structure. Its value without distress costs would be USD 500 million. If distress occurs, direct and indirect costs total 15% of that value. Ignoring other effects, what is the expected cost of financial distress?

The expected cost of financial distress is USD 30 million. Distress costs are 15% of USD 500 million, or USD 75 million, and this is weighted by the 40% probability of distress, giving 0.40 times 75, which equals USD 30 million.

  1. AUSD 30 millionCorrect
  2. BUSD 75 million
  3. CUSD 200 million
  4. DUSD 12.5 million

Explanation

Cost if distressed = 15% x 500 = USD 75 million. Expected cost = 0.40 x 75 = USD 30 million. USD 75 million ignores the probability; USD 200 million applies 40% to the full value instead of the cost.

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