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

Under the trade-off theory of capital structure, which statement best describes the optimal debt level for a firm whose assets are highly intangible and whose business relies heavily on customer and supplier confidence?

Optimal debt is lower for such a firm. Intangible assets and confidence-dependent relationships lose much of their value in distress, so expected distress costs rise faster with leverage, and the trade-off between tax shields and distress costs is reached at a lower debt level.

  1. ALower, because expected distress costs rise quickly with leverage and intangible assets lose value more in distressCorrect
  2. BHigher, because intangible assets provide strong collateral for creditors
  3. CHigher, because tax shields are larger when assets are intangible
  4. DUnaffected, because distress costs are independent of asset type

Explanation

Firms with intangible assets and reliance on stakeholder confidence suffer larger losses of value in distress, since intangibles cannot be sold at book value and relationships erode. This raises the cost side of the trade-off, lowering optimal leverage. Tangible assets, not intangibles, support collateral.

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