2. Agency conflicts between shareholders and creditors

While the agency conflicts between managers and shareholders tend to receive the most press, they are not the only type of agency conflict affecting the modern corporation. Another equally important type of agency conflict is sometimes observed between a firms common shareholders and its creditors, or bondholders. As with conflicts between managers and shareholders, the basis of conflicts between shareholders and bondholders 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 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 firms bondholders will be , while that of the firms shareholders will be .

Agency conflicts between shareholders and creditors

Bondholders often employ a variety of devicesincluding restrictive covenants in the companys bond indenture agreementsto protect their interests and constrain the actions of shareholders and the firms managers.

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

Provisions that prohibit reducing the firms liquidity ratio below specified levels

Provisions that require firing the firms CEO whenever the firms bond price decreases by more than 15%

Provisions that prohibit the borrower from increasing debt ratios above specified levels

Provisions that disallow the repurchase of stock or paying dividends unless profits and retained earnings are above specified amounts

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

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