In financial distress, equity has an incentive to take on large risks in order to increase the value of the equity call option.

Question

Quizplus · Accepted Answer

Equity holders in financial distress have limited options for increasing the value of their investment, and may be incentivized to take on large risks in order to potentially generate higher returns. This is because equity is essentially a call option on the company's assets, meaning that the more valuable the assets become, the more valuable the equity becomes. However, this strategy can also increase the likelihood of bankruptcy or further financial distress, so it is not always the optimal choice.

In Financial Distress, Equity Has an Incentive to Take on Large