When a Firm in Financial Distress Accepts Very Risky Projects

question 23

Multiple Choice

When a firm in financial distress accepts very risky projects, the stockholders benefit at the expense of the bondholders. In terms of option theory, the gain to the stockholders occurs because:

• A) the stock is a put option on the firm's assets, and risky projects decrease the exercise price of the option.
• B) the stock is a put option on the firm's assets, and risky projects increase the exercise price of the option.
• C) the stock is a call option on the firm's assets, and risky projects increase the volatility of those assets.
• D) the stock is a call option on the firm's assets, and risky projects decrease the volatility of those assets.

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Definitions:

Dollar-Weighted Return

A method of calculating an investment's return that accounts for the timing and magnitude of cash flows into and out of the investment.

Dollar-Weighted Return

A method of calculating an investment's return that considers the timing and amount of capital inflows and outflows.

Dividend

A portion of a company's earnings distributed to its shareholders, usually in the form of cash or additional stock.

Sharpe Measure

A measure for calculating the performance of an investment compared to a risk-free asset, after adjusting for its risk, often used to understand the risk-adjusted return.