Asked by Alyssa Currie on Jul 09, 2024

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The following statements about asset substitution are true except for:

A) Managers have incentives to use debt finance to invest in higher-risk assets with the expectation of obtaining higher returns for shareholders.
B) Lenders are willing to share higher returns earned when managers invest in higher-risk projects.
C) A debt covenant that restricts investment opportunities of the entity can reduce the entity's borrowing costs.
D) Asset substitution arises when an entity uses borrowed funds to invest in higher risk assets than those agreed upon in the debt contract.

Asset Substitution

A financial strategy where a firm replaces less risky assets with more risky investments, potentially increasing shareholders' wealth but also the risk to lenders.

Debt Covenant

Agreements between a borrower and lender stating specific limitations or conditions about the borrower's actions.

Borrowing Costs

Expenses incurred by an entity for borrowing funds, including interest, amortization of discounts or premiums on debt, and other related costs.

  • Acquire knowledge on the core concepts of accounting theories, which include normative and positive theories along with their developmental stages.
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Renata BauteJul 11, 2024
Final Answer :
B
Explanation :
Lenders are typically not willing to share higher returns earned when managers invest in higher-risk projects as they are more concerned about getting their principal and interest payments back. Asset substitution can occur when managers invest in higher-risk assets than those agreed upon in the debt contract, but a debt covenant that restricts investment opportunities of the entity may not necessarily reduce borrowing costs.