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FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies

A distressed manufacturer with risky debt outstanding has an opportunity to invest in a positive-NPV project that would mainly benefit existing bondholders by making their claims safer. Equity holders decline to fund it. This behavior is best described as which agency cost of financial distress?

This is the underinvestment problem, also called debt overhang. Because the project's gains largely go to bondholders, shareholders will not fund it even though its NPV is positive, so firm value is destroyed. Asset substitution instead involves favoring riskier projects.

  1. AAsset substitution
  2. BUnderinvestment (debt overhang)Correct
  3. CClaim dilution
  4. DRisk shifting through asset sales

Explanation

Debt overhang means that when much of a positive-NPV project's payoff accrues to creditors, shareholders refuse to fund it, so value is lost. Asset substitution is the opposite: taking riskier projects to benefit equity at creditors' expense.

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