Firms can avoid or limit the asset substitution problem by:
A) funding with equity.
B) establishing a reputation for protecting creditors.
C) insuring bondholders against risk.
D) applying to the government for insurance for bondholders.
E) a, b, and c.

Question

Quizplus · Accepted Answer

The asset substitution problem occurs when a firm undertakes riskier projects than creditors expected, potentially harming creditors' interests. Funding with equity (A) avoids this issue by not increasing debt risk. Establishing a reputation for protecting creditors (B) can mitigate the problem by building trust. Insuring bondholders against risk (C) directly addresses the concern by compensating for potential losses. These measures can limit the asset substitution problem, making E (a, b, and c) the correct choice.

Firms Can Avoid or Limit the Asset Substitution Problem By