W7

Which statement is MOST accurate about financial distress costs vs. bankruptcy costs (trade‑off theory context)?

Static trade‑off (tax shields vs expected distress costs). A firm has VU = £500m and can issue perpetual debt D (in £m) at par. Corporate tax rate Tc = 25%. If bankruptcy occurs, the PV of total distress costs is £500m. Probability of bankruptcy depends on D as: D=200→5%, D=600→15%, D=900→32%, D=1400→60%. Ignoring personal taxes/agency effects, which D maximizes VL = VU + Tc·D − p(D)·500?

Expected PV of distress costs. A firm has pre‑distress asset value of £1.20bn. If it enters bankruptcy at the end of year 1, direct costs are 3.5% of assets and indirect costs are 15% of assets. The probability of bankruptcy over the next year is 32%. Use a 10% discount rate to compute the expected PV of distress costs today.

Default and expected return on risky debt. KBS Retail will liquidate in 1 year. Boom prob.=60% with total firm cash flow £260m; recession prob.=40% with cash flow £120m. Debt due in 1 year is £180m. The market value of outstanding debt today is £125m (no taxes). What is the expected return on the debt over the year (based on expected payoff / current price − 1)?

Asset substitution (risk shifting). A distressed firm has debt with face value £1,000,000 due in 1 year. If it does nothing, asset value at year‑end will be £950,000. It can instead adopt a risky strategy (no upfront cost): with 50% probability assets become £1,400,000; with 50% probability assets become £200,000. Assuming creditors are paid up to face value, what is the change in bondholders’ expected payoff if shareholders choose the risky strategy rather than the status quo?

Covenant to neutralize risk shifting. A firm must pay bondholders £50,000 in 1 year. Managers can choose one project (equal probabilities of good/bad). Low‑volatility project pays £40,000 (bad) or £80,000 (good). High‑volatility project pays £5,000 (bad) or £110,000 (good). Bondholders propose a covenant: if the firm chooses the high‑vol project, the promised debt payment becomes X (instead of £50,000). What X makes shareholders indifferent between choosing low‑vol vs high‑vol?