The possibility of bankruptcy has a negative effect on the value of the firm because:
A)increased bankruptcy risk always lowers value.
B)reorganization is costless but risk is not.
C)a bankruptcy has real costs associated with it.
D)value enhancing strategies are no longer available.
E)None of the above.

Question

Quizplus · Accepted Answer

Bankruptcy has real costs associated with it, including legal and administrative costs, loss of reputation, and potential fire sales of assets. These costs decrease the value of the firm because they represent expenses that cannot be recouped in the form of higher profits or cash flows. Increased bankruptcy risk also commonly lowers the value of a firm, but this is not always the case. Reorganization may involve costs and risks, but it is not costless, so choice B is incorrect. Choice D is too general and does not provide a clear explanation of why bankruptcy lowers value. Choice E is not a valid response because it does not describe a specific reason why bankruptcy may have a negative effect on value.

The Possibility of Bankruptcy Has a Negative Effect on the Value