solution

More on agency conflicts and costs

While the agency conflicts between managers and shareholders tend to receive the most press, they are not the only agency conflict affecting the modern corporation. Another equally important agency conflict is sometimes observed between a firm’s common shareholders and its bondholders. As before, the basis of this conflict is divergent concerns and motives. In general, bondholders purchase corporate securities that provide a return, whereas shareholders purchase shares that are likely to provide a return that fluctuates with the riskiness of the firm.

If managers undertake projects that decrease the riskiness of the firm and its cash flows, then the wealth of the firm’s bondholders will be , while that of the firm’s shareholders will be .

Agency conflicts between shareholders and creditors

Bondholders often employ a variety of devices—including restrictive covenants in the company’s bond indenture agreements—to protect their interests and constrain the actions of shareholders and the firm’s managers.

Which of the following are restrictive covenants often used to protect the firm’s bond value and bondholder wealth? Check all that apply.

Provisions that limit dividends paid to stockholders

Provisions that prohibit borrowing funds to pay dividends

Provisions that require firing the firm’s CEO whenever the firm’s bond price decreases by more than 15%

Provisions that limit the type of investments or divestments that the firm can undertake

In addition, potential bondholders may require a interest rate on the firm’s soon-to-be-issued bond as compensation for the risks that cannot be adequately protected against using the restrictive covenants.