The following statements about asset substitution are true except for:
A) Managers have incentives to use debt finance to invest in higher-risk assets with the expectation of obtaining higher returns for shareholders.
B) Lenders are willing to share higher returns earned when managers invest in higher-risk projects.
C) A debt covenant that restricts investment opportunities of the entity can reduce the entity's borrowing costs.
D) Asset substitution arises when an entity uses borrowed funds to invest in higher risk assets than those agreed upon in the debt contract.

Question

Quizplus · Accepted Answer

Lenders are typically not willing to share higher returns earned when managers invest in higher-risk projects as they are more concerned about getting their principal and interest payments back. Asset substitution can occur when managers invest in higher-risk assets than those agreed upon in the debt contract, but a debt covenant that restricts investment opportunities of the entity may not necessarily reduce borrowing costs.

The Following Statements About Asset Substitution Are True Except For