The under-investment problem refers to the problem that equity holders prefer not to invest in positive-NPV projects in highly levered firms because
A)gains are evenly shared between all stakeholders.
B)most of the gains from the investment accrue to debt holders.
C)future investments are contingent on debt financing.
D)projects are contingent on equity financing.

Question

Quizplus · Accepted Answer

In highly levered firms, most of the gains from positive-NPV projects go to debt holders. This is because as a firm becomes more leveraged, the risk of default increases, and therefore the cost of debt increases. As a result, debt holders demand a higher rate of return to compensate them for this increased risk, which means that they end up with a larger share of the firm's cash flows. This can create a situation where equity holders are reluctant to invest in positive-NPV projects because they will not receive a large enough share of the benefits. This is known as the under-investment problem.

The Under-Investment Problem Refers to the Problem That Equity Holders