Debt holders versus shareholders, Financial Management

Debt holders versus Shareholders

A second agency problem arises because of potential conflict between stockholders and creditors. Creditors lend finances to the firm at rates which are based on:

  1. Riskiness of the firm's existing assets
  2. Expectations concerning the riskiness of future assets additions
  3. The firm's existing capital structure
  4. Expectations regarding future capital structure modifications.

These are the factors which determine the riskiness of the firm's cash flows and therefore the safety of its debt issue. Shareholders (acting via management) might make decisions that will cause the firm's risk to change. This will influence the value of debt. The firm might raise the level of debt to boost profits.  This will decrease the value of old debt since it raises the risk of the firm.

Creditors will defend themselves against the above troubles through:

(A) Insisting on uncertain covenants to be incorporated in the debt contract. Such covenants might limit:

•    The company’s benefit base
•    The company’s capability to get additional debts
•    The company’s capability to pay future dividend and management compensation.
•    The management capability to make future judgment (control associated covenants)

(B) When creditors observe that shareholders are trying to take benefit of them in unethical manners, they will either decline to deal further with the firm or else will need a much higher than normal rate of interest to recompense for the risks of such feasible exploitations.

It thus follows that shareholders wealth maximization need fair play with creditors. This is as shareholders wealth based on continued access to capital markets that depends on fair play by shareholders as far as creditor's interests are anxious.

Posted Date: 12/8/2012 6:58:45 AM | Location : United States

Related Discussions:- Debt holders versus shareholders, Assignment Help, Ask Question on Debt holders versus shareholders, Get Answer, Expert's Help, Debt holders versus shareholders Discussions

Write discussion on Debt holders versus shareholders
Your posts are moderated
Related Questions
Assume that your company has an equity position in a French firm. Explain the condition under which the dollar/franc exchange rate uncertainty does not comprise exchange exposure f

Balance Sheets   Peony Ltd. Aster Ltd. Assets:     Cash $     62,500 $

1) According to the IFE (RIP), if U.S. investors expect a 3% rate of domestic inflation over one year, and a 6% rate of inflation in European countries that use the EUR, and requir

Provide three examples of mutually exclusive projects. Mutually exclusive projects are projects which participate against each other for our selection.  If a organization and fir

Determination of spread Daily interest rate = 5.11/ 365 = 0.014% per day Variance of cash flows = 1000 × 1000 = $1000000 per day Transaction cost = $18 per transaction

The relative change in the yield for each treasury maturity is known as a shift in the yield curve. When the change in the yield for all the maturities is same, t

Jessica is given the opportunity to invest $5,000 now and receive $5,700 at the end of one year. However, she could only invest $1,000 of her own money and would need to borrow the

Cash flow duration, like effective duration, considers the change in the cash flow due to prepayment with the change in the interest rate. In effective duration,

Claim for Refund - A refund isn't automatically mailed if one is due. A taxpayer whether individual orbusiness, should file a request on a form. It should also be filed within the

Q. Show the Advantages of adjusted discount rate? Advantages:- (1) It is simple to understand and simple to calculate. (2) The risk premium rate comprised in the risk adj