Asset Substitution Problem

In a traditional asset substitution problem scenario, a company's management willingly deceives another by replacing higher quality assets (or projects) with lower quality assets (or projects), after a credit analysis has already been performed. For instance, a company could sell a project as low risk to get favorable terms from creditors, after loan funding, they could use the proceeds for risky endeavors, hence, passing the unforeseen risk to creditors.

The issue boils down to risk shifting: when an asset substitution occurs, managers make overly risky investment decisions that maximize equity shareholder value at the expense of debtholders’ interests.

The asset substitution problem highlights the conflicts between stockholders and creditors. Because creditors have a claim on a firm's earnings stream, they have a claim on its assets in the event of bankruptcy. However, common equity shareholders have control (by way of managerial control) of decisions affecting a firm's riskiness. Thus, creditors delegate decision-making authority to someone else, creating a potential agency conflict. See also the principal-agent problem.

Creditors lend money at rates based on a firm's perceived risk at the time of credit extension, which in turn is driven by: 1. the risk of the firm's existing assets, 2. any expectations regarding the risk of future asset additions, 3. the existing capital structure, and 4. any expectations concerning potential future capital structure changes.

Imagine a firm borrows money, then sells its relatively safe assets and invests the money in assets for a new project that is far riskier. The new project could be extremely profitable, but it could also let to financial distress or even bankruptcy. If the risky project is successful, most of the benefits to the equity shareholders because creditors' returns are fixed at the original low-risk rate. However, if the project is a failure, the bondholders take a loss.

In this case, the stockholder's claim on a levered company can be viewed as a call option on the firm's asset value. Because equity downside risk is limited, managers of levered firms have incentives to increase the riskiness of the firm's business - so they may substitute safe assets with risky assets, to raise the upside potential of this option. The incentive to shift risk grows with a company's level of leverage. At the extreme, even projects with negative present value may be chosen simply because of their high risk and big upside. In a sense, stockholders get a "heads, I win; tails, you lose" payoff situation.