Question

The following statements about asset substitution are true except for: Select one:

a. A debt covenant that restricts investment opportunities of the entity can reduce the entity's borrowing costs.
b. Lenders are willing to share higher returns earned when managers invest in higher-risk projects.
c. Managers have incentives to use debt finance to invest in higher-risk assets with the expectation of obtaining higher returns for shareholders.
d. Asset substitution arises when an entity uses borrowed funds

Answer 1

Statement b, that lenders are willing to share higher returns from higher-risk projects, is false as lenders expect repayment irrespective of the project's risk, with the increased potential returns typically benefitting shareholders.

Step-by-step explanation:

The correct answer to the question regarding statements about asset substitution is b. Lenders are willing to share higher returns earned when managers invest in higher-risk projects. This is not true because lenders, as providers of debt, typically expect to be repaid with interest, independent of the risk level of the projects funded by the debt. The potential for higher returns typically accrues to the shareholders, not the debt holders. This concept is tied to the risk-shifting behavior, where managers might have an incentive to invest in riskier projects after debt financing is secured, in hopes of generating higher returns for shareholders at the expense of creditors.

Point a articulates that a debt covenant can indeed reduce borrowing costs if it restricts investments in riskier projects, thus aligning the interests of the creditors and the owners. Point c discusses the incentive for managers to pursue higher-risk investments when financed with debt, which corresponds with the objective of maximizing shareholder value.