Indicate whether the following are true or false and briefly explain why:

1) The asset substitution problem stems from the incentive that equity holders have to

increase the volatility of the assets in order to transfer value from the debt holders to

themselves. For this reason, in equilibrium, the debt holders will receive an expected

return lower than their opportunity cost of capital. [3 points]

2) In a Modigliani-Miller world (with perfectly competitive markets, no friction and no

taxation) the value of the firms assets is not affected by the capital structure choice.

For this reason, if the capital structure is changed, the expected return on assets stays

unchanged although the expected return on equity varies. [3 points]

3) If a firm has a debt overhang problem, it forgoes future positive NPV investment

opportunities. Hence debt overhang only affects the future value of the firm not the

current one