© The Financial Times Ltd 2014 FT and 'Financial Times' are trademarks of The Financial Times Ltd.
Risk shifting, which is also known as asset substitution, occurs if managers make overly risky investment decisions that maximise shareholder value at the expense of debtholders’ interests.
A stockholder's claim on a levered company can be viewed as a call option on the group's asset value. Since equity downside risk is limited, managers of levered firms have incentives to increase the riskiness of the firm's business - so they substitute safe assets with risky assets, to raise the upside potential of this option.
The incentive to shift risk increases with a company's leverage. At the extreme, even projects with negative present value may be chosen simply because of their high risk.
Highly levered companies often bear extremely high costs of debt financing because debt investors ask for a premium to outweigh the negative consequences of risk-shifting incentives.