The asset substitution problem occurs when
A) managers substitute more risky assets for less risky ones to the detriment of bondholders.
B) managers substitute less risky assets for more risky ones to the detriment of bondholders.
C) managers substitute more risky assets for less risky ones to the detriment of equity holders.
D) managers substitute less risky assets for riskier ones to the detriment of equity holders.

Question

Quizplus · Accepted Answer

The asset substitution problem refers to the incentive of managers to substitute more risky assets for less risky ones, which can increase the value of equity but decrease the value of debt. This can occur when a firm issues debt and later the manager decides to invest the funds in riskier assets, which increases the expected return on equity but also raises the likelihood of default, decreasing bondholders' expected return. Therefore, choice A is the correct answer.

The Asset Substitution Problem Occurs When