Question

4. When financial distress is near or incurred in a levered firm, there is an incentive to take large risk by some of the key stakeholders in the firm. By following this strategy,
   1. the stockholders/managers in the firm will rank all projects and take the project which results in the highest expected value of the firm.
   2. bondholders expropriate value from stockholders by selecting high risk projects.
   3. stockholders expropriate value from bondholders by selecting high risk projects.
   4. the firm will always take the low risk project.
   5. both A and B.

Answer 1

To explain this, lets take an example. A firm has net Equity of negative -$100, also it has a loan of $100.

If the firm goes in liquidation today, stockholders will get nothing becasue equity value is negative. Bondholders might get some scrap value of the asset sold. Bond holders have higher claim during liquidation.

In such situation, if a new project comes. Stockholder has nothing to loose. They will take on high risk projects because anyways they don't have any payout. However, if the high risk project succeds, they might be able to turn there return positive.

This leads to stockholders ignoring the risk and taking risky projects.

OPTION C mentions this point. Correct answer.

Option B is wrong becasue bondholders don't have the right to choose projects.

Option A is wrong becasue high expected value doesn't always mean high risk project.