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

A leveraged buyout target has EBITDA falling 30% after a demand shock, while its fixed debt payments are unchanged. Which feature of the firm most explains why the fall in earnings pushes it into distress so quickly?

High operating and financial leverage explain it. Fixed costs and fixed debt payments do not fall when earnings decline, so a 30% drop in EBITDA causes a much larger proportional fall in cash available to service debt, quickly pushing the firm toward distress.

  1. AHigh operating and financial leverage magnify the effect of revenue declines on cash available for debt serviceCorrect
  2. BA high dividend payout ratio
  3. CLow inventory turnover
  4. DA diversified customer base

Explanation

Fixed operating costs and fixed debt payments mean a revenue decline causes a proportionally larger fall in cash available for debt service. A diversified customer base would reduce, not increase, vulnerability. Dividends and inventory turnover are secondary and not the main amplifier.

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