One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result in:
A) the firm always choosing projects with the positive NPVs.
B) the firm accepting negative NPV projects that it would clearly reject in an all equity firm.
C) bondholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.
D) both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.
E) both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

Question

Quizplus · Accepted Answer

Underinvestment occurs when a firm, due to the presence of debt, turns down positive NPV projects it would accept if it were all equity financed. This is because the benefits of the investment might accrue more to the bondholders at the expense of the shareholders, especially if the firm is in financial distress. Hence, shareholders might prefer not to invest even in positive NPV projects. Additionally, when investments are made, both stockholders and bondholders share in the benefits, but often the stockholders bear the full investment cost, especially in distressed situations, making them reluctant to invest.

One of the Indirect Costs to Bankruptcy Is the Incentive