One of the indirect costs of bankruptcy is the incentive for managers to take large risks.When following this strategy:
A)the firm will rank all projects and take the project which results in the highest expected value of the firm.
B)bondholders expropriate value from stockholders by selecting high risk projects.
C)stockholders expropriate value from bondholders by selecting high risk projects.
D)the firm will always take the low risk project.
E)Both A and B.

Question

Quizplus · Accepted Answer

When managers know that bankruptcy is a possibility, they may take on riskier projects in an attempt to save the company. However, this can result in larger losses and potential default, which can hurt bondholders who have less protection than equity holders in bankruptcy proceedings. As a result, equity holders may select high-risk projects to potentially gain a larger return at the expense of bondholders. This is referred to as expropriation of value from bondholders. Therefore, Choice C is the best option.

One of the Indirect Costs of Bankruptcy Is the Incentive