Debt holders versus shareholders, Financial Management

Assignment Help:

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.


Related Discussions:- Debt holders versus shareholders

Predicting cross-sectional returns, Predicting Cross-Sectional Returns ...

Predicting Cross-Sectional Returns If the market is assumed to be efficient, all securities should lie along the security market line that relates the expected rate of return t

Cyclical variation in time series analysis, Cyclical Variation By cycli...

Cyclical Variation By cyclical variations, we refer to the long-term movement of the variable about the trend line. Therefore, does the movement of the actual series about a tr

What is capital recovery, Q. What is Capital recovery? sometimes one ma...

Q. What is Capital recovery? sometimes one may be interested to find out the annual amount paid in the order to redeem a loan of a specific amount over a specific period togeth

Budget, Details on budgetary control process

Details on budgetary control process

Define why it is hard to maintain a fixed exchange rate, Once capital marke...

Once capital markets are integrated, it is hard for a country to maintain a fixed exchange rate. Explain why this may be so. Answer: one time capital markets are integrated int

Determine the analytical procedures of auditors, Analytical procedures of a...

Analytical procedures of auditors Auditors must apply analytical procedures at the planning and overall review stage of audit. Analytical procedures include the considerati

What are a bank''s primary reserves, What are a bank's primary reserves ? ...

What are a bank's primary reserves ? When the Fed sets reserve requirements, what is its primary goal? Vault deposits and cash in the bank's account at the Fed are used to pe

Excess of the inadequate of the working capital, Every business concern sho...

Every business concern should have neigh adequate capital to run the business operations it should have neither redundant nor excess working capital non inadequate or Shortage of

Calculate the investment in a project, BAGS, Inc. is considering an investm...

BAGS, Inc. is considering an investment in a new project. The required investment is $1,000,000. After-tax net cash flows are expected to be $50,000 the first year and are expected

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd