The underinvestment problem occurs in a financially distressed company when:
A) the value of investing in a positive-NPV project is likely to go to debt holders instead of equity holders.
B) the value of investing in a positive-NPV project is likely to go to equity holders instead of debt holders.
C) management invests in negative-NPV projects to reduce their own risk.
D) issuing equity becomes difficult due to increased risk.

Question

Quizplus · Accepted Answer

In financially distressed companies, the value of investing in a positive-NPV project is likely to go to debt holders instead of equity holders. This is because the company's equity holders are likely to face significant losses in bankruptcy, while debt holders have a higher priority in receiving compensation. As a result, equity holders may not be willing to invest in positive-NPV projects, leading to underinvestment.

The Underinvestment Problem Occurs in a Financially Distressed Company When