As the lender...consider this; does good collateral make a bad loan good?

1.) The usual collateral position of Bondholders (Lenders) versus Equity investors The usual collateral position of Bondholders (Lenders) is held in liquid accounts. Bondholders have financial interest in the firm in the form of principal and interest payments that they are going to receive whereas equity investors have ownership in the firm. They are the recipients of dividends that the company may give or may not give depending upon the cash cushion that it has. 2.) Why common stockholders can demand a higher rate of return than lenders, The rate of return depends on the risk that a firm takes. With the investment financing done through debts, managers in the company have to bring discipline in the investment that they do. They have the fear of bankruptcy. They hold the commitment to pay interest and principal to bondholders. As managers bring discipline in the investments, they are usually reluctant to take the risk due to fear of bankruptcy and hence do not take much risk. In case the debt financing is too high, the managers become reluctant to take an even slightest risk in the kind of investment that they do. In comparison to that, if the company has done financing through equity, managers have discretionary spending power over the cash flow from operations. They can use this cash to be distributed to equity holders in the form of dividends or invest in assets or let the cash be idle. They have the cash cushion against the kind of investment that they do. Hence, they can invest in any risky project to get substantial high returns. As managers of company get this flexibility in equity financing, equity investors demand a higher rate of return than lenders. 3.) Why you would suggest debt (or equity) financing. Debt financing typically has two major benefits: 1.) Tax advantage in interest payments that the company gets, which they do not receive in dividend payouts 2.) Discipline that the managers need to follow when they invest in debts Jenny Wallace