Asset substitution problem

Asset substitution problem

Arises when the stockholders substitute riskier assets for the firm's existing assets and expropriate value from the debtholders.

Asset Substitution

A company's exchange of lower-risk investments for higher-risk investments. Firms may use asset substitution as a form of financing, or as a move to please shareholders. It can be detrimental to the company's bondholders as it increases the possibility of default without any corresponding benefit because bonds have a fixed interest rate. On the other hand, asset substitution can benefit shareholders as it carries the possibility of higher returns.
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This problem, a variation of which is also known as the "asset substitution problem", has been recognized before, but only in terms of imminent default.
A positive RA, before the threshold is reached, is consistent with our standard understanding of an asset substitution problem.
Johnson, 1997a, 1997b employs the ratio of fixed assets to total assets (FAR) as a proxy for the assets that can be used as collateral to reduce the asset substitution problem associated with debt.
More assets-in-place implies a smaller potential for asset substitution problems, and a lesser need for monitoring (Johnson, 1997a).
To the extent that MB is a measure of intangible assets, it could also be a proxy for potential asset substitution problems. Given the special role attributed to private lenders in theoretical models, it might then be expected that MB will be positively related to the use of private debt.
(For an early discussion of the asset substitution problem, see Jensen and Meckling, 1976.) Investments that maximize the firm's expected value but risk partial default therefore may be passed over in favor of riskier projects.
Johnson (1997a) and Johnson (1997b) employ the ratio of fixed assets to total assets as a proxy for the assets that can be used as collateral to reduce the asset substitution problem. The reduction in asset substitution problems should increase access to public debt.
The fixed asset ratio (FAR) measures the value of the firm's assets that might be used as collateral in order to mitigate asset substitution problems. Finally, the firm's leverage (LEV) is also included as a negative indicator of the firm's agency costs of debt.
At the same time, joint incorporation creates an asset substitution problem which does not exist when projects are incorporated separately.
By contrast, with SI the bondholders encounter no asset substitution problem, and the entrepreneur retains more flexibility in his leverage decisions.
When the two projects' volatilities are more similar to one another (the upper pair of lines), the asset substitution problem is less severe and JI is chosen over a broad range of values for |Rho~ -- specifically, for |Rho~ |is less than~ 0.90.
Zhang (2007) indicates that this argument is true for firms with severe asset substitution problems, particularly all equity firms with high growth potential.