FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies
A hedge fund analyst argues that a highly indebted firm will underinvest in positive-NPV projects because most of the benefit would accrue to existing creditors. This phenomenon is best described as:
This is debt overhang. When a firm is heavily indebted, shareholders bear the cost of new investment while much of the payoff goes to creditors, so they forgo positive-NPV projects. Asset substitution is different, because it involves taking excessive risk rather than underinvesting.
- AAsset substitution
- BDebt overhangCorrect
- CRisk shifting by creditors
- DFire-sale discounting
Explanation
Debt overhang occurs when shareholders decline positive-NPV projects because gains go mainly to debt holders. Asset substitution is the opposite incentive: taking riskier projects to transfer value from creditors to equity.
Did you get it right without looking?
One question tells you little. A timed set on Distress Symptoms and Remedies shows your real accuracy, how long you take and where you lose marks.
More Distress Symptoms and Remedies questions
- A distressed firm files under Chapter 11. A hedge fund analyst asks what happens to the firm's management and creditors' collection efforts …
- In a Chapter 11 case, a plan of reorganization is being voted on by classes of creditors. Under the Bankruptcy Code, a class of claims is de…
- A retailer files for Chapter 11. Its management continues to run day-to-day operations and proposes a reorganization plan. Which feature of …
- A fund holds the fulcrum security in a restructuring, where the enterprise value of USD 500 million is allocated as follows: first-lien loan…
- Which of the following is a typical reason an out-of-court restructuring may fail and force a firm into formal bankruptcy?
- Which of the following is the most typical early market-based symptom that a firm with publicly traded debt is moving toward distress?