Question

1. Which of the following problem(s) is/are likely to arise at financially distressed firms?

1. Debt overhang
2. Overinvestment in safe projects
3. Asset substitution

1. I only
2. II only
3. I and II
4. I and III
5. I, II and III

Answer 1

Answer E --- All of three are correct

In a fiancial distress firm, the debt may not be available even when the better investment opportunity ocurs which give positive but risky returns. The creditors will prefers to Invest in only those projects which are less risky so that their money will remain safe to certain extent. So both the debt overhung and overinvestment in safe projects occured. But managers on the other hand would be interested in those projects which give a high return in future as loan providers will have a limited stake on the future income (equal to the interest). Also the downside for equity, (if the project fails), is limited. So they will substitute less risky assets with the more risky assets. Thus assets substitution occurs.