Task 2.

3
Costs to creditors, investment banking costs, costs of accounting experts, legal costs and fees, loss
of receivables are direct costs of bankruptcy.
False. Costs to creditors and loss of receivables are indirect costs.

Loss of customers, loss of employees, delayed liquidation and the costs of appraisers hired by the
firm’s creditors are indirect costs of financial distress.
False. Appraisers are direct costs.

When securities are fairly priced, only the original shareholders of the firm and not the
debtholders pay the present value of the financial distress and bankruptcy costs.
True. The debtholders require a higher rate of return on debt because the riskiness of the investment
increased by the financial distress. There is less money available for dividends, repurchase shares,
and make investments. This difference comes from the equity holders.

The present value of financial distress costs are lower for high beta firms than for low beta firms.
False. The higher the beta the more likely it will be in distress in an economic downturn, and thus the
more negative the beta of its distress costs will be. Because a more negative beta leads to a lower
cost capital the present value of the distress costs will be higher.

According to the Tradeoff Theory, as the level of debt, D, increases, the tax benefits of debt
increase by t*D until the interest expense exceeds the firm’s EBIT.
True.

According to the Tradeoff Theory, the optimal level of debt D* decreases as the probability of
default and the costs of distress increase.
True.

Assume a Modigliani and Miller world with bankruptcy cost as an imperfection. DoubleTrouble (DT)
has a value of $500 million if it continues to operate but has outstanding debt of $600 million. If DT
declares bankruptcy, bankruptcy costs will equal $50 million and the remaining $450 million will go
to creditors. Instead of declaring bankruptcy, DT proposes to exchange the firm's debt for a fraction
of its equity in a workout. - For the workout to be successful, the minimum fraction of the firm's
equity that DT would need to offer to its creditors is closest to 50% / 75% / 83% / 90%.

Assume a Modigliani and Miller world with bankruptcy cost as an imperfection. Elmo Incorporated
(EI) in ready to launch a new product. Depending upon the success of this product, EI will have a
value of either €100 million, €150 million, or €191 million, with each outcome being equally likely.
The cash flows are unrelated to the state of the economy (i.e. risk from the project is diversifiable) so
that the project has a beta of 0 and a cost of capital equal to the risk-free rate, which is currently 5%.
In the event of bankruptcy, 20% of the value of EI's assets will be lost in bankruptcy costs. - EI’s
unlevered firm value is closest to €150 million / €147 million / €140 million / €133 million.

Assume that capital markets are perfect except for the existence of corporate taxes and financial
distress costs. Clothing retailer Collage Clothing (CC) is currently an unlevered firm with a share price
of €10.00 per share and with 25 million shares outstanding. CC pays a 40% corporate tax rate. CC
announces plans to lower its corporate taxes by borrowing €100 million and using the proceeds to
repurchase shares. CC’s shareholders expect this change in debt to be permanent. - If the price of
CC’s stock rises to €10.80 per share following the announcement, then the present value of CC’s
financial distress costs will be closest to €20 million / €60 million / €80 million / €100 million.