Stockholders Versus Creditors

Debt, Interest, Leverage (finance)

Agency Conflict 2: Stockholders versus Creditors
Conflict of interest can also arise between stockholders and creditors. Stockholders may take decisions that increase their return on debt which eventually leads to decrease in the value of the debt. Creditors also have a claim on the earnings and assets of the firm for the payment of interest and principal and in case of bankruptcy. Creditors are providers of long term debt of capital. They lend funds at rates that are based on; 1. The risk of the existing asset structure.

2. The risk of the expected asset structure.
3. The existing capital structure or gearing level of the firm. 4. The expected capital structure or gearing level of the firm.

These are the indicators of the safety of the debt issues. Now, the conflict could arise in a manner that stockholders(through managers) may sell the safe assets which are as collaterals for the debt or are from the debt funds into riskier projects which have a higher rate of return. But the chances of failure are also high but as the stockholders would only loose the same fixed amount so, they go for riskier projects to increase their return on debt. However, if project fails creditors will have to also bear the loss. But for the stockholders it would be the same amount. Shareholders will have higher returns on success and the value of debt will go down. But the creditors will receive the same return at old low risk rates.

Similarly, another e.g. could be that managers may borrow money to repurchase shares to lower the corporations share base and increase stockholders return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows. It would also reduce the value of debt for the stockholders.

Stockholders should not reduce the wealth of the creditors. As, in the long run it is not in the interest of the stockholders. The creditors in the future would refuse to give credit on...
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