The possibility of bankruptcy has a negative effect on the value of the firm because:

I. Increased bankruptcy risk lowers value.
II. Reorganization is costless but risk is not.
III. A bankruptcy has real costs associated with it.
IV. Value enhancing strategies are no longer available.

Correct Answer: I and III

Companies in distress tend to have a harder time meeting their financial obligations, which translates to a higher probability of default.