Lecture 1

Question 1

Economic distress

Answer 1

Firms generating low or negative operating income and/or have a problematic business model

Question 2

What is often used as an empircal indicator of financial distress?

Answer 2

Bankruptcy

Question 3

Financial Distress

Answer 3

A company is unable to generate enough revenue to meet financial obligations

Question 4

If a company does not have debt which type of distress can it not have?

Answer 4

Financial distress

Question 5

Technical insolvency

Answer 5

A firm is unable to meet its debt as they come due

Question 6

Balance sheet insolvency

Answer 6

A firm’s total liabilities exceeds its total assets

Question 7

technical default

Answer 7

borrower violates a provision other than a scheduled payment (can be a covenant breach)_

Question 8

formal default

Answer 8

borrower misses interest or principle payment

Question 9

Bankruptcy

Answer 9

a firm enters a court-supervised bankruptcy procedure

Question 10

what type of restructurings are there?

Answer 10

Asset restructuring
- improve operating performance and cash-flows
redeploy underperfoming assets

equity and liabilitiews: financial restructuring
- out of court restructuring, in court restructuring or liquidation
- legal aspects and coordiaitno are key to preserve asset value

Question 11

what is the difference between discrete and continous random variables

Answer 11

discrete have a fixed value, like throwing a dice
continous rnadom variables are for example stock returns

Question 12

what are two statistical measures to characterize random variables?

Answer 12

Expected value, like a dice throw is expected to yield 3.5 on average
standard deviation (volatility) like stock returns

Question 13

why do we discount? and where does the discount rate consists of

Answer 13

we discount because of the risk, the discount rate consists of the time value of money + risk

Question 14

what are simplifications that are typically made in finance applications for stocks?

Answer 14

constant discount rate like WACC
not specify probability distributions, but take expectations ( constant dividend (growth) in gordon growth model, DCF free cash-flows do not have a probability distribution)

Question 15

what is the difference between simple and advanced equity pricing models and what are examples of advanced equity pricing models?

Answer 15

they do not typically make these simplificaitons, they specify time-series behaviour (probability distributio) of cash-flows. examples are: Merton Model, opiton pricing model and credit risk models
examples of not simplifying:
- yield curve- different risk-free rate for different time horizons
- binominal tree for call option price- approximate probability distribution
- credit risk literature- distinguish default and non-default state

Question 16

where can we apply a simple stochastic model?

Answer 16

• Security pricing
• Evaluate corporate investment decisions
• Trading strategies
• Strategic analysis
• Predictions about legal changes

Question 17

Calculate the risk-free bond price, the risk adjusted bond price and the npv of distress costs (omega):

default probability p = 0.05
loss-given default (w) = 0.6
discount rate (r) = 0.05
Face value (f) = 1

Answer 17

risk free bond price = 1/1.05 = 0.9524
risk adjusted bond price = 0.95 * 1/1.05 + 0.05 * ((1-0.6)/1.05) = 0.9238
NPV of distress costs = 0.05 * 0.6/1.05 = 0.0286