Which of the following statements about asset substitution is incorrect:
A) Managers have incentives to use debt finance to invest in higher-risk assets.
B) When managers invest in higher-risk projects, lenders would share higher returns earned from the projects.
C) The problem of asset substitution can be reduced by having a debt covenant that restricts investment opportunities of the entity.
D) Asset substitution increased the risk borne by lenders.

Question

Quizplus · Accepted Answer

This statement is incorrect because when managers invest in higher-risk projects, the lenders do not necessarily share the higher returns earned from the projects. The lenders receive a fixed interest rate, and they do not benefit from any increase in the project's profitability. Instead, the managers benefit from any extra returns earned beyond the interest rate, leading to a potential conflict of interest known as asset substitution.

Which of the Following Statements About Asset Substitution Is Incorrect