Lent Term - Lecture 4

Question 1

Why does the shareholder not internalise loss in the low state of debt financing?

Answer 1

Limited liability

Question 2

What is asset substitution?

Answer 2

This is where investors anticipate that equityholders will choose a riskier project with a potential higher return and as a result will demand a higher face value of debt

Question 3

When is there a market breakdown in asset substitution?

Answer 3

When the 2nd project had a negative NPV. This happens regardless of whether the first project is positive or not.

Question 4

Why is there no asset substitution problem with equity finance?

Answer 4

There is no distortion in E’s investment decision because they take the less risky option

Question 5

What are the capital structure implications of asset substitution?

Answer 5

Firms that face more frequent managerial discretion with regard to risk should have less debt

Question 6

How can you mitigate asset substitution?

Answer 6

• Short-term debt allows for negotiation of the lending rate to adjust for higher risk so there is less incentive to take risks
• Covenants e.g. prohibiting investment into new unrelated lines of business
• Convertible debt: Debtholders will switch to equity in times of high returns so there’s less incentive to take risk as E would not be the sole receiver of the high return

Question 7

Why is equity financing not possible when considering effort?

Answer 7

The required equity stake would be too large so that the manager would not exert effort leading to a negative NPV investment

Question 8

What incentives does debt give to managers?

Answer 8

It gives them an incentive to put in high effort. If the additional cash flows from high effort are not greater than private benefit then the manager will shirk.