A situation that arises when a firm's equity is close to worthless, and equity holders will prefer to invest in overly risky projects with a small chance of success rather than simply paying debt holders their regularly schedule payments is referred to as _____________________.

Question

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The situation described is known as the overinvestment problem. When a firm's equity is close to worthless, equity holders may see little benefit in making debt payments and may instead opt to take overly risky investments that have a small chance of success. This is a consequence of the weakened position of the equity holders, as they have little reason to prioritize debt repayment when their equity is worth so little. The underinvestment problem, on the other hand, refers to a situation in which a firm may avoid taking on profitable projects because of a reluctance to take on debts that would dilute their equity. Separation principle refers to the idea that a firm's financing decisions should be separate from its investment decisions, and passive capital structure management refers to a strategy of maintaining a fixed capital structure over time.

A Situation That Arises When a Firm's Equity Is Close