How does corporate investment risk-taking change when a firm has high leverage or approaches distress? In high-leverage states of the world, equity holders benefit from successful outcomes of high-risk projects, while losses from unsuccessful outcomes are borne by debt holders. This asymmetry between who receives the gains and losses from a project could make it optimal for equity holders to maximize the amount of risk a firm undertakes when leverage is high. This hypothesized increased risk-taking in a firm’s investments, referred to as risk-shifting or asset substitution, could result in an overall cost to the firm.
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