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IAI Actuarial Core Principles · Business Finance · Key principles of finance

A highly geared company approaches distress. Shareholders push management to replace a safe project with a riskier one with the same expected cash flow. Which statement best explains why shareholders favour this change?

Shareholders gain because limited liability makes equity resemble a call option on the firm's assets. Higher project variance raises its value while bondholders, whose upside is capped, bear more of the downside. This transfer of wealth is the asset substitution problem.

  1. AHigher risk increases the value of debt, so lenders gain
  2. BEquity has limited liability and behaves like a call option, so its value rises with project variance while bondholders bear more of the downsideCorrect
  3. CThe change lowers the firm's total expected cash flows but raises accounting profit
  4. DShareholders are compensated by a lower cost of debt
  5. Risk is fully diversified by lenders, so it has no effect

Explanation

With limited liability, shareholders' losses are capped while upside is open, as with a call option on firm assets. Greater variance raises option value at the expense of debt holders, who bear more downside with a capped return. This is the asset substitution problem. Debt value falls, not rises, so option A is wrong.

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