A financially distressed firm incurs financial distress costs…

Question

BlackTom AI · Accepted Answer

Question restatement: A financially distressed firm incurs financial distress costs… and you are given several multiple-choice options to explain when these costs arise.

Option a: "a. when its manager accepts low-risk investment projects to maximise shareholder value." This option attributes financial distress costs to a specific managerial behavior (accepting low-risk projects) aimed at maximizing value. While risk posture can influence firm value and risk profile, financial distress costs are tied to distress in financing and information asymmetry, not simply to the choice of low-risk projects. Therefore this option does not correctly describe when distress costs are incurred.

Option b: "b. as soon as the firm files for bankruptcy." Financial distress costs do increase around distress and bankruptcy, but the key point is that costs begin to accrue well before formal bankruptcy filing due to agency problems, adverse selection, and signaling effects. So stating that costs occur only after filing ignores the pre-bankruptcy costs that have already materialized.

Option c: "c. None of the options provided." This would be selected only if all other statements were incorrect. Given that there is a statement that aligns with the nature of distress costs before bankruptcy (option d), this option is not correct.

Option d: "d. even though it may never actually file for bankruptcy." This captures the essential idea: a firm can incur substantial financial distress costs even without ever filing for bankruptcy, because costs arise from symptomatic factors like higher interest spreads, monitoring, short-selling costs, increased financing constraints, and the value-decreasing effects of distress signals. The costs manifest due to the existence of distress risk, not the bankruptcy outcome itself.

Option e: "e. when its manager overinvests to maximise shareholder value." Overinvestment can lead to negative outcomes and misallocation of resources, potentially increasing distress risk, but distress costs themselves are not defined as arising strictly from overinvestment. This option mischaracterizes the timing and source of distress costs, which are driven by distress signals and financing constraints rather than the act of overinvesting itself as a trigger.

Synthesis: Distress costs are associated with the presence of financial distress and the signaling, agency, and information problems that come with it. Those costs can be incurred before formal bankruptcy and do not require actual bankruptcy filing. Hence, option d best captures the timing and nature of financial distress costs, while the other options misattribute causes or the timing of when these costs occur.

A financially distressed firm incurs financial distress costs…

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