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

Which statement about the trade-off between the tax benefits of debt and the costs of financial distress is most accurate?

Firms with volatile cash flows and many intangible assets should generally use less leverage. They face a higher probability of distress and larger value losses in liquidation, so expected distress costs offset the interest tax shield sooner than for stable, tangible-asset firms.

  1. AFirms with highly volatile cash flows and many intangible assets should generally choose lower leverage because expected distress costs are higherCorrect
  2. BFirms with intangible assets can lever more because intangible assets keep their value in liquidation
  3. CDistress costs rise only once bankruptcy is formally filed, so leverage is unaffected before then
  4. DHigher leverage always raises firm value because interest is tax deductible

Explanation

Volatile cash flows raise the probability of distress, and intangible assets lose much value in liquidation, so expected distress costs are high and optimal leverage is lower. Intangibles do not hold value in liquidation, and indirect costs arise before filing.

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