AIM 1: Identify the circumstances under, which risk management reduces the present value of costs of financial distress.

1、Risk management to reduce the probability of financial distress:

A) can increase firm value because financial distress has measurable costs. 

B) always increases firm value. 

C) is easily replicated by individual shareholders. 

D) cannot reduce the weighted average cost of capital.

The correct answer is A

Financial distress will take up management time and energy and possibly lead to stricter terms from suppliers and loss of customers.?Therefore, reducing the probability of financial distress can increase firm value.

2、Which of the following strategies may increase firm value by decreasing the costs of bankruptcy and financial distress?

Reducing the potential costs of financial distress and bankruptcy.

Reducing the weighted average cost of capital.

Improving management incentives.

Reducing information asymmetries.

A) I only. 

B) I and II only. 

C) I and III only. 

D) I, II, and IV only.

The correct answer is B

Strategies I and II both suggest risk management to reduce the cost of bankruptcy and financial distress may be value enhancing.

AIM 2: Explain why risk management may lower a firm’s tax bill using carry-forwards and carry-backs.

1、In the presence of taxes, risk management activities can create value by:

A) minimizing each year’s taxable income. 

B) postponing taxes indefinitely. 

C) shifting the realization of taxable income from years when it is low to years when it is high. 

D) shifting the realization of taxable income from years when it is high to years when it is low.

The correct answer is D

Given a progressive tax rate structure, risk management activities can reduce the firm's tax liability by shifting the realization of taxable income from years when it is high to years when it is low.

AIM 3: Demonstrate how risk management by changing the optimal capital structure of the firm, may increase firm value.

1、Risk management may change the optimal capital structure of the firm because:

A) it will increase the returns on equity. 

B) less debt will be required to fund assets. 

C) the tax benefits of debt financing will be increased. 

D) less probability of financial distress supports a greater use of debt.

The correct answer is D

According to the tradeoff theory of capital structure, the tax benefits of using more debt financing at some point are outweighed by the increasing probability of bankruptcy/financial distress.?Reducing the probability of financial distress will increase the amount of debt in the optimal capital structure.

AIM 5: Explain the relationship between risk management, managerial incentives, and the structure of management compensation.

1、Reduction of risks not under management’s control:

A) can lead to lower incentive compensation. 

B) may cause managers to overinvest. 

C) makes stock options more valuable.  

D) cannot improve management incentives.

The correct answer is A

When the uncertainty about firm performance that is not a result of management decisions and actions is reduced, incentive compensation for management is a less-risky source of compensation for managers, and they will accept a contract with lower expected incentive compensation as a result.