Shareholders in a levered firm might wish to accept a negative net present value project if it:
A)increases the standard deviation of the returns on the firm's assets.
B)lowers the variance of the returns on the firm's assets.
C)lowers the firm's volatility.
D)diversifies the cash flows of the firm.
E)decreases the risk that a firm will default on its debt.

Question

Quizplus · Accepted Answer

Shareholders in a levered firm might be inclined to accept a negative net present value project if it increases the standard deviation of the returns on the firm's assets. This is because the increased risk (higher standard deviation) can potentially lead to higher returns for the shareholders, especially if the firm is in a situation where the benefits of successful outcomes disproportionately accrue to the shareholders due to the presence of debt (leverage). This is related to the concept of risk-shifting or asset substitution, where shareholders prefer riskier projects in the presence of debt, as the downside risk is partially borne by the debt holders.

Shareholders in a Levered Firm Might Wish to Accept a Negative