The underinvestment problem occurs in a financially distressed firm 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 firms, the value of investing in a positive NPV project is likely to go to debt holders instead of equity holders because the firm must prioritize paying its debts to avoid default or bankruptcy. This creates the underinvestment problem where the firm may not invest in profitable projects because the benefits would primarily go to debt holders, leaving little for equity holders.

The Underinvestment Problem Occurs in a Financially Distressed Firm When