Question

One of the indirect costs to bankruptcy is the incentive toward underinvestment. Following this strategy may result in:

Both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

Both the firm always choosing projects with the positive NPVs; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

the firm always choosing projects with the positive NPVs.

the firm turning down positive NPV projects that it would clearly accept in an all equity firm.

Answer 1

Correct option:

Both the firm turning down positive NPV projects that it would clearly accept in an all equity firm; and stockholders contributing the full amount of the investment, but both stockholders and bondholders sharing in the benefits of the project.

This happens because as a company becomes highly leveraged, the return to stockholders, after having paid bondholders, is insufficient for the investors to invest even in positive NPV projects. The stock holders end up making full investments because already the company is highly leveraged and there is no possibility of raising any more debt and any benefits are shared by both stock and bond holders.