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

A risk manager at a mid-sized industrial firm is explaining to the board why high leverage can reduce firm value even before a bankruptcy filing occurs. Which of the following is best classified as an indirect cost of financial distress?

Customers leaving because they doubt warranties will be honored is an indirect cost of financial distress. Indirect costs are lost sales and other opportunity costs from perceived weakness, whereas legal, administrative and restructuring advisory fees are explicit out-of-pocket direct costs of bankruptcy.

  1. ALegal fees paid to outside counsel during a Chapter 11 proceeding
  2. BFees paid to a court-appointed administrator
  3. CCustomers switching to competitors because they doubt the firm will honor warrantiesCorrect
  4. DFees paid to investment bankers to restructure the debt in court

Explanation

Indirect costs are opportunity costs and lost business arising from perceived distress, such as lost customers, suppliers tightening terms and loss of key staff. Legal, administrative and advisory fees from a formal proceeding are direct costs, which are explicit cash outlays.

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