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

A firm has USD 500 million of debt with face value due in one year and assets whose market value is USD 450 million. Equity holders retain an option-like claim. Which statement is most accurate regarding the incentives of equity holders in this situation?

With assets of USD 450 million below USD 500 million of debt, equity is an out-of-the-money call option whose value rises with asset volatility. Shareholders therefore may prefer risky, even negative-NPV projects, shifting downside to creditors. This risk-shifting, or asset substitution, problem is a classic distress agency cost.

  1. AEquity holders will favor low-risk projects since they bear all losses
  2. BEquity holders may favor high-risk, even negative-NPV, projects because they gain from upside while creditors bear much of the downside, a risk-shifting problemCorrect
  3. CEquity holders will always inject new equity to pay down debt because the equity is in the money
  4. DEquity holders are indifferent to asset volatility because debt is fixed

Explanation

Assets are below the debt face value, so equity is an out-of-the-money call. Higher asset volatility raises option value, giving shareholders an incentive to gamble (asset substitution) at creditors' expense. Option one has the incentive reversed, and equity is not in the money, so injecting equity is not rational.

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