A firm’s default risk, the measurement of the chances

Question

A firm’s default risk, the measurement of the chances of the event in which the company will be unable to make the required payments on its debt obligations, reflects not only the likelihood that the firm will have bad luck but also the risk that the firm’s managerial decisions will lead the firm to default. Such management risk occurs because the impact of management on the firm’s value is uncertain, and this uncertainty affects the market’s perception of a firm’s risk. Uncertainty about management is likely to be the highest when there is a new management team and should decrease over time as management’s ability becomes known more precisely. In particular, when the new CEO is not considered an “heir apparent” prior to getting the position, or when he comes from outside of the company, or when the new CEO is younger, the market is expected to perceive relatively high uncertainty about the CEO’s ability or future actions. Accordingly, it comes as no surprise that the CDS spread, a measure of a firm’s expected default risk, is about 35 basis points higher when a new CEO takes office than three years into his tenure. The CEO, however, is not the only member of the management team who is relevant for decision making in the firm. Chief Financial Officers (CFOs) have a large role in financial decision-making, so uncertainty about new CFOs could also affect the firm’s default risk and cost of borrowing.

Now, a central feature of financial markets is that the interest rate a firm pays on debt increases with an increase in the market’s perception of the firm’s risk. This risk occurs because of factors that affect the value of the firm’s underlying assets and because of uncertainty about how these assets will be managed. The literature on debt pricing typically does not distinguish between these types of underlying risks. However, all risks, including those generated by uncertainty about management, affect the likelihood of default. Consequently, a rational market should incorporate managerial-generated uncertainty into its assessment of a firm’s risk when pricing its securities. Also since uncertainty about management affects firms’ costs of borrowing and consequently their financial policies, the value of maintaining transparency in managerial policies and communicating them to the marketplace should be realised.   1 
1.Which of the following statements would the author most likely agree with?
A. Even though uncertainty about a new CEO’s ability has more impact on a firm’s default risk, uncertainty about a new CFO could affect the rate at which the firm is lent money and its default risk
B. The uncertainty about a new CEO is likely to be comparably lower when an expected candidate takes over the position vis-à-vis an unexpected one.
C. Because the literature on debt pricing normally does not differentiate between the types of risks, sometimes the default risk is not calculated thoroughly.
D. As the tenure of a new CEO progresses, the uncertainty regarding his ability decreases considerably.
E. By maintaining transparency in managerial policies, a firm can successfully negotiate its terms in the market.

2 
2.The author is primarily concerned with
A.highlighting the importance of a risk factor that is normally not easily understood in the business world
B.discussing how a particular factor, though important, gets neglected most of the time
C. describing how a risk factor in the business world gets more importance in some situations than in others
D. explaining how different risk factors need to be given importance as per their relative weightage
E. discussing the relevance of a risk factor that affects more than one aspect in the business world

3 
3. Which of the following CANNOT be inferred from the passage?
A. Market’s perception of firm’s risk is minimal when the new CEO is an “heir apparent” or is from within the existing management team.
B. The uncertainty regarding a new CEO is likely to be more in the first years of his tenure than in the fourth year.
C. The default risk of a firm represents more than one thing about the firm.
D. It is unusual for a piece of literature on debt pricing to differentiate between the risk generated from the factors affecting a firm’s asset and one generated from how these assets will be managed.
E. Uncertainty about management affects a firm’s financial policies.

4 
4. Which of the following is mentioned in the passage?
A.The default risk, as per the CDS spread, is highest when the new CEO of a firm is younger than an average CEO.
B. Besides the CFO and the CEO, there are other members in a firm whose decisions could affect default risk.
C. The literature on debt pricing normally ignores underlying risks.
D.As the perception of the market regarding a firm’s risk increases, the rate at which the firm pays interest on debt also increases.
E. The uncertainty surrounding the perception of a firm’s risk leads to management risk.

Nikhil · Accepted Answer

1. Which of the following statements would the author most likely agree with?

A. Even though uncertainty about a new CEO’s ability has more impact on a firm’s default risk, uncertainty about a new CFO could affect the rate at which the firm is lent money and its default risk.

Incorrect : Partial Scope

Although the author does state that uncertainty about a new CFO could affect a firm’s default risk and cost of borrowing, there is no information given to compare this effect with the impact resulting from uncertainty about a new CEO’s ability.

B. The uncertainty about a new CEO is likely to be comparably lower when an expected candidate takes over the position vis-à-vis an unexpected one.

Correct

This information can be deduced on the basis of the following information:

In particular, when the new CEO is not considered an “heir apparent” prior to getting the position… the market is expected to perceive relatively high uncertainty about the CEO’s ability or future actions.

C. Because the literature on debt pricing normally does not differentiate between the types of risks, sometimes the default risk is not calculated thoroughly.

Incorrect : Out Of Scope

The author neither states nor suggests the cause and effect relationship stated in this choice.

D. As the tenure of a new CEO progresses, the uncertainty regarding his ability decreases considerably.

Incorrect : Out Of Scope

Although it is given that the uncertainty decreases with the passage of time, the passage gives us no information to support that it decreases “considerably”.

E. By maintaining transparency in managerial policies, a firm can successfully negotiate its terms in the market.

Incorrect : Out Of Scope

There is no given information to deduce anything about a firm’s success in negotiating its term.

2. The author is primarily concerned with

A. highlighting the importance of a risk factor that is normally not easily understood in the business world

Incorrect : Inconsistent

Yes, the author does highlight the importance of management related risk but there is no information to support that this risk is not easily understood.

B. discussing how a particular factor, though important, gets neglected most of the time

Incorrect : Irrelevant

The author does say the literature on debt pricing does not differentiate between risks, but the passage never delves in to discussing that the factor is ignored.

C. describing how a risk factor in the business world gets more importance in some situations than in others

Incorrect : Inconsistent

This information is given while discussing the situations in which the uncertainty about management is higher. However, this is only a part of the entire discussion- not the main focus.

D. explaining how different risk factors need to be given importance as per their relative weightage

Incorrect : Irrelevant

There is no mention of/discussion over relative weightage of risk factors.

E. discussing the relevance of a risk factor that affects more than one aspect in the business world

Correct

The author discusses the relevance of management related risk and yes, the passage gives us enough information to conclude that this risk affects default risk, cost of borrowing, financial policies etc.

3. Which of the following CANNOT be inferred from the passage?

A. Market’s perception of firm’s risk is minimal when the new CEO is an “heir apparent” or is from within the existing management team.

Correct

First of all, a firm’s risk is a combination of management related and other risks. So, we cannot draw a sweeping statement about a firm’s risk by estimating just management related risk. Secondly, there is no given information to support that management related risk will be “minimal” under the given circumstances.

B. The uncertainty regarding a new CEO is likely to be more in the first years of his tenure than in the fourth year.

Incorrect : Can be Inferred

The author gives us enough throughout the passage to conclude the information given in this choice. For specific mention, one could refer to the following portion:

Accordingly, it comes as no surprise that the CDS spread, a measure of a firm’s expected default risk, is about 35 basis points higher when a new CEO takes office than three years into his tenure.

C. The default risk of a firm represents more than one thing about the firm.

Incorrect : Can be Inferred

This statement can be inferred from the first sentence of the passage.

D. It is unusual for a piece of literature on debt pricing to differentiate between the risk generated from the factors affecting a firm’s asset and one generated from how these assets will be managed.

Incorrect : Can be Inferred

We can infer the information given in this choice from the following portion:

The literature on debt pricing typically does not distinguish between these types of underlying risks.

E. Uncertainty about management affects a firm’s financial policies.

Incorrect : Can bededucedred

This can be deuced from the following section in the second paragraph:

Also since uncertainty about management affects firms’ costs of borrowing and consequently their financial policies…

We can conclude from the above portion that the uncertainty affects the cost of borrowing, which in turn affects the financial policies of the firm.

4. Which of the following is mentioned in the passage?

A. The default risk, as per the CDS spread, is highest when the new CEO of a firm is younger than an average CEO.

Incorrect : Out of Scope

The author does mention this age related scenario but does not say anything about it leading to the “highest” default risk.

B. Besides the CFO and the CEO, there are other members in a firm whose decisions could affect default risk.

Incorrect : Out of Scope

The author states that the CEO is not the only member of the management team who is relevant for decision making in the firm and then gives the example of CFO. However, the author does not state there are more members beyond these two.

C. The literature on debt pricing normally ignores underlying risks.

Incorrect : Out of Scope

The author states that the literature does not differentiate between these risks and not that it ignores them.

D. As the perception of the market regarding a firm’s risk increases, the rate at which the firm pays interest on debt also increases.

Correct

This information is explicitly given to us in the first statement of the final passage.

E. The uncertainty surrounding the perception of a firm’s risk leads to management risk.

Incorrect : Out of Scope

This cause and effect relationship is completely out of scope. In fact, it is the uncertainty regarding the management that gives contributes to the perception of firm’s risk.

tamal99 · Answer

Could anyone please explain Answers of Q. no 2 and 3.

Thanks in advance.

push12345 · Answer

tamal99

i can give it a try

2)  As per passage Firm's default risk "reflects not only the likelihood that the firm will have bad luck but also the risk that the firm’s managerial decisions will lead the firm to default."

As per above statements Choice E is best option

3)Passage
 Uncertainty about management is likely to be the highest when there is a new management team and should decrease over time as management’s ability becomes known more precisely. In particular, when the new CEO is not considered an “heir apparent” prior to getting the position, or when he comes from outside of the company, or when the new CEO is younger, the market is expected to perceive relatively high uncertainty about the CEO’s ability or future actions.

Choice A)Here we dont know whether risk is minimal when any member is from existing management team.
No info is provided on this thats why we cant say for sure to this.
Hence this is the answer

Give kudos if it helps

KS15 · Answer

How did you eliminate C in Qs 2? I know it is between C and E but I can't find a way to eliminate C.

AkshdeepS · Answer

12: 48 minutes : All correct : Good passage.

Q : 3 was a bit confusing.

shrupk · Answer

Hello,

Can anyone explain why the answer to Q1 is B and not D?

Thanks.

yashwanthnallam · Answer

Can u please post all answers??

Sent from my Redmi Note 3 using  GMAT Club Forum mobile app

AkshdeepS · Answer

3. Which of the following CANNOT be inferred from the passage?

D. It is unusual for a piece of literature on debt pricing to differentiate between the risk generated from the factors affecting a firm’s asset and one generated from how these assets will be managed.

Incorrect : Can be Inferred

We can infer the information given in this choice from the following portion:

The literature on debt pricing typically does not distinguish between these types of underlying risks.

Hey workout,

Can we deduce that far from the above mentioned statement. Though, the literature does not distinguish between XYZ, can we infer as Unusual thing".

Isn't it a far fetched inference?

u1983 · Answer

Please tag the intended person as ------  workout  or  u1983  ....... else ur message will not reach them. As the person might not be reading all the posts in the particular forum(forum-section).

danielgold20 · Answer

Booommm!!!

4/4 I see an improvement in mt RC section Thanks great passage!!!

agrasan · Answer

Hi experts  KarishmaB   GMATNinja   MartyMurray   DmitryFarber   GMATNinjaTwo   egmat

In question-1, am not clear why option C is wrong.

(C) Because the literature on debt pricing normally does not differentiate between the types of risks, sometimes the default risk is not calculated thoroughly.

My reasoning is we can say that risk management won't be done properly if those risks are not captured properly based on the following lines from the passage. Is it wrong because we don't know which risk from  ALL RISKS  is causing or there is  NO causal relationship  these two factors  (debt pricing literature's inability to differentiate risks and default risk)  in the passage?

"Now, a central feature of financial markets is that the interest rate a firm pays on debt increases with an increase in the market’s perception of the firm’s risk. This risk occurs because of factors that affect the value of the firm’s underlying assets and because of uncertainty about how these assets will be managed. The literature on debt pricing typically    does not distinguish    between these types of underlying risks. However,    all risks   , including those generated by uncertainty about management,    affect the likelihood of default.   "

Please let me know where I am faltering here.

A firm’s default risk, the measurement of the chances

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GMAT Reading Comprehension (RC) Questions

A firm’s default risk, the measurement of the chances

Prep Toolkit

615 to 715 in 15 Days (Ria's Strategies)

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My Rewards