Asset Substitution Problem

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DEFINITION of 'Asset Substitution Problem'

A problem that arises when a company exchanges its low-risk assets for high-risk investments. This substitution transfers value from a firm's bondholders to its shareholders.

BREAKING DOWN 'Asset Substitution Problem'

The transfer of assets places more risk on the debt holders without providing them with additional compensation. High-risk projects can yield higher profits, however more risk is incurred by the firm. The added profit may only benefit the shareholders, as the bondholders require only a fixed return. The increase level of risk does affect the bondholders, since the company increases its chance of defaulting on its debt.

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