Question

a company issues bonds claiming that the proceeds will be invested in a safe project. however, it uses the proceeds for a risky investment. which of the following statements is true? the value of the debt will increase since the company is riskier. issuing the bonds decreases the financial risk of the firm because bonds are less risky than equities. switching to a risky investment compromises the debtholders' interests. stockholders will be against the switching because their interests are compromised. none of the above.

Answer 1

Switching to a risky investment compromises the bondholders' interests because they face an increased risk of default with no added benefit. Stockholders may support the switch due to the potential for higher returns, even though it introduces greater financial risk.

Step-by-step explanation:

In the scenario where a company issues bonds claiming the proceeds will be used for a safe project, yet then takes the high risk route, the statement that switching to a risky investment compromises the debtholders' interests is true. Issuing bonds does not inherently decrease the financial risk because bonds are a fixed obligation, and in this context, the firm is engaging in activities that have higher default risk. Bondholders potentially face greater risk of default when a company takes on riskier projects, because if the project fails, the firm may not be able to fulfill its debt obligations. Meanwhile, the statement that the stockholders will be against the switching does not always hold true as they stand to gain if the risky project succeeds, without bearing the direct risk of the debt.