Under-investment problems refers to the problem that equity holders prefer not to invest in positive-NPV projects in highly levered firms because ________.
A) future investments are contingent on debt financing
B) projects are contingent on equity financing
C) gains are evenly shared between all stakeholders
D) most of the gains from the investment accrue to debt holders

Question

Quizplus · Accepted Answer

Under-investment problems occur when equity holders avoid investing in projects with positive net present value because most of the benefits from the investment accrue to debt holders. Since the firm is highly leveraged, debt holders have priority over equity holders in receiving payments, and equity holders may not see a significant return on their investment. Therefore, equity holders may prefer to let the firm continue with its current operations rather than investing in new projects.

Under-Investment Problems Refers to the Problem That Equity Holders Prefer