Financial Distress and Managerial Incentives Assignment Questions


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Essay Questions


Financial Distress and Managerial Incentives


Question 1: When a firm defaults on its debt, debt holders often receive less than 50% of the amount they are owed. Is the difference between the amount debt holders are owed and the amount they receive the cost of bankruptcy? Explain.


Question 2: You work for a large car manufacturer that is currently financially healthy. Your manager feels that the firm should take on more debt because it can thereby reduce the expense of car warranties. To quote your manager, “If we go bankrupt ,we don’t have to service the warranties. We therefore have lower bankruptcy costs than most corporations, so we should use more debt.” Is he right?


Question 3: Real estate purchases are often financed with at least 80% debt. Most corporations, however, have less than 50% debt financing. Provide an explanation for this difference using the tradeoff theory.


Question 4: Although the major benefit of debt financing is easy to observe the tax shield many of the indirect costs of debt financing can be quite subtle and difficult to observe. Describe some of these costs.


Question 5: Discuss several direct and indirect costs of bankruptcy. What is the impact of indirect costs?


Question 6: Illustrate an optimum capital structure by using a diagram. Please also explain your answer.


Question 7: How is Trade-off theory used to explain optimum leverage? Justify your answer.


Question 8: Discuss the agency costs of leverage. Provide examples.


Question 9: What are the problems with excessive risk-taking and over-investment?


Question 10: Explain debt overhang and under-investment. Please provide examples.