Frost1 Motors is very likely to enter financial distress. Without a dramatic change of events over the next couple of years, the company will be unable to pay its lenders, who will then gain control of the company's assets. A group of stockholders has pressured the company's management to begin manufacturing and selling one of the company's concept cars in the hope that it will be a big hit. Concept cars are prototypes that are developed to test new ideas and to show off at auto shows. Although elements of concept cars are often incorporated into product lines, rushing a concept car into production is very risky. The best estimates about the concept car make it appear to be a negative-NPV project. This is a good example of:

Question

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The asset substitution problem occurs when a firm's managers, acting in the interest of shareholders, undertake risky projects to maximize their wealth at the expense of debt holders. In this case, the management's decision to rush a concept car into production, despite it being a negative-NPV project, in hopes of saving the company from financial distress, is a classic example of substituting less risky assets with more risky ones, potentially harming the lenders.

Frost1 Motors Is Very Likely to Enter Financial Distress