FRM Part II · FRM Exam Part II · Distress Symptoms and Remedies
A highly levered company with risky debt passes up a positive-NPV project because most of the project's gains would accrue to existing creditors rather than shareholders. This behavior is best described as:
This is the debt overhang, or underinvestment, problem. Shareholders of a distressed levered firm decline positive-NPV projects because the benefits flow mainly to creditors, so value is lost. Asset substitution is different, since it involves taking riskier projects rather than rejecting valuable ones.
- ADebt overhang (underinvestment) problemCorrect
- BAsset substitution problem
- CRisk shifting through higher volatility
- DWinner's curse
Explanation
When equity holders refuse positive-NPV investments because the payoff mainly benefits debtholders, the result is debt overhang, or underinvestment. Asset substitution involves taking riskier projects, not rejecting good ones.
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