Asset Substitution and Risk Shifting
Shareholders of a heavily indebted firm have an incentive to swap safe projects for riskier ones, because they keep all the upside while lenders absorb most of the downside.
Prerequisites: Direct and Indirect Costs of Financial Distress, The Debt vs Equity Financing Decision
Equity in a leveraged company behaves a lot like a call option on the firm's assets: shareholders get everything above what's owed to debt, and nothing below zero — bankruptcy caps their downside at the equity they've already lost. Option holders love volatility. So do shareholders of a distressed firm, and that creates a dangerous incentive: swap a safe, sensible project for a wild, risky one, even if the risky one has lower expected value, because shareholders capture the extra upside while lenders eat the extra downside.
This is asset substitution, sometimes called risk shifting, and it is one of the clearest ways the interests of shareholders and lenders diverge once a firm is levered and near distress.
Equity's payoff is capped at zero on the downside but unlimited on the upside, so equity holders in a distressed, levered firm benefit from adding risk to the business even when it destroys total firm value — because lenders, not shareholders, absorb most of the extra downside.
Why the incentive appears
Consider a firm with $100 of debt due shortly and two mutually exclusive projects it could run instead of its current safe business:
- Safe project: pays $100 for certain.
- Risky project: 50% chance of paying $180, 50% chance of paying $20.
The risky project's raw expected payoff, , works out to $100 — tied with the safe project on paper. But real risk-shifting examples typically make the risky choice worse in expected value once a risk discount is applied: assume the market discounts the risky payoff to an expected $90 in present-value terms, meaning it genuinely destroys value relative to the safe project.
Now look at what each project pays equity, after debt of $100 is paid first:
| Project | Debt gets | Equity gets |
|---|---|---|
| Safe ($100 certain) | $100 | $0 |
| Risky, good state ($180) | $100 | $80 |
| Risky, bad state ($20) | $20 | $0 |
Equity's expected payoff under the risky project, , comes to $40, versus $0 under the safe project. Shareholders strictly prefer the risky, value-destroying project, because debt absorbs the entire loss in the bad state while equity keeps all of the gain in the good state.
What this means in practice
This is why loan agreements are packed with restrictions on what a borrower can do with the money: covenants limiting new business lines, capital expenditure, asset sales, and additional debt exist largely to stop shareholders from gambling with lenders' money once things get tight. It's also why lenders price debt to distressed or highly levered firms more conservatively, and why credit agreements often tighten sharply as a company's leverage climbs — the lender is pricing in the risk that management's incentives are about to change.
Risk shifting doesn't require bad faith or fraud — it can be the fully rational result of an unremarkable capital structure. A management team acting entirely in shareholders' interest, exactly as it's supposed to, can still be pushed toward destroying firm value once debt is large enough relative to assets. The fix is structural — covenants, monitoring — not moral.
Further reading
- Jensen & Meckling, 'Theory of the Firm' (1976)
- Berk & DeMarzo, Corporate Finance (ch. 16)