Asset Substitution Problem
What Is an Asset Substitution Problem?
An asset substitution problem is the point at which a company's management energetically hoodwinks one more by supplanting higher quality assets (or projects) with lower quality assets (or projects) after a credit analysis has previously been performed. For example, a company could sell a project as generally safe to get positive terms from creditors, after loan funding, they could involve the proceeds for risky undertakings — hence, passing the unanticipated risk to creditors.
How an Asset Substitution Problem Works
The asset substitution problem highlights the struggles among investors and creditors. Since creditors have a claim on a firm's earnings stream, they have a claim on its assets in the event of bankruptcy. Notwithstanding, common equity shareholders have control (via managerial control) of choices influencing a firm's riskiness. Hence, creditors delegate dynamic authority to another person, making a potential agency problem.
Creditors loan money at rates in light of a firm's perceived risk at the hour of credit extension, which thus is driven by:
- The risk of the firm's existing assets.
- Any expectations with respect to the risk of future asset augmentations.
- The existing capital structure.
- Any expectations concerning potential future capital structure changes.
The issue reduces to risk-shifting — when an asset substitution happens, managers settle on excessively risky investment choices that boost equity shareholder value to the detriment of debtholders' interests.
Illustration of an Asset Substitution Problem
Envision a firm gets money, then sells its generally safe assets and puts the money in assets for another project that is far riskier. The new project could be extremely productive, yet it could likewise let to financial distress or even bankruptcy.
Assuming the risky project is effective, the vast majority of the benefits to the equity shareholders in light of the fact that creditors' returns are fixed at the original okay rate. Be that as it may, on the off chance that the project is a disappointment, the bondholders assume a loss.
In this case, the investor's claim on a levered company can be seen as a call option on the firm's asset value. Since equity downside risk is limited, managers of levered firms have incentives to increase the riskiness of the firm's business — so they might substitute safe assets with risky assets, to raise the upside capability of this option.
The incentive to shift risk develops with a company's level of leverage. At the extreme, even projects with a negative present value might be picked just in view of their high risk and large upside. It could be said, investors get a "heads, I win; tails, you lose" payoff situation.
Highlights
- The incentive to shift risk develops with a company's level of leverage.
- Asset substitution problems emerge when management deluded by supplanting higher quality projects or assets with lower quality projects or assets.
- The asset substitution problem highlights the struggles among investors and creditors.
- The key asset substitution problem is risk-shifting, which is when managers pursue excessively risky investment choices that augment equity shareholder value to the detriment of debtholders' interests.
