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.