Conflict of interest between shareholders and bondholders_Marek

Conflict of interest between shareholders and bondholders_Marek

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(Marek Jochec) This little exercise illustrates the possible conflict of interest between shareholders (or managers representing shareholders) and bondholders, that arises when a company has an excessive amount of debt. The cause of this conflict is the nature of debt (a fixed claim) and the nature of equity (a residual claim); this results in unequal risk sharing: the losses are born by both shareholders and bondholders, while the gains are enjoyed only by shareholders. This limited downside risk with unlimited upside potential makes shareholders to prefer risky projects (i.e. projects with highly variable possible cash flows). The underlying reason is the property of corporations called limited liability . I. No Debt Consider a 100% equity company, with the only asset: $100 of cash. The (market value) balance sheet then looks like this: A L/SE 100 (cash) 100 (owner’s equity) Now the company is considering two projects: “RiskyBad” and “SafeGood”, or RB and SG for short. RB is a gambling game, where all the cash is invested in period zero a bet on flipping a coin. In period one, if the outcome is head, you receive $150, if tail, you receive zero: head (probability ½): 150 RB: 100 tail (probability ½): 0 SG is a an investment in period zero that gives $110 in period one with certainty: SG: 100 (with probability 1) 110 At this point you may wonder why the risky project is bad, and why the safe project is good. Expected outcome of the risky project is ½ * 150 + ½ * 0 = 75. Even ignoring the discounting for one period, we already see that 75 < 100. On the other hand, the safe project is good because it provides a riskless rate of return of 10%, assumably more than other safe alternatives. (For example, let’s imagine that government security that pays money in period one provides rate of return 5%). ( Note on the side: If you wonder what would be an example of RG (RiskyGood) and SB (SafeBad) projects: head (probability ½): 150 RG: 100 tail (probability ½): 110 SB: 100 (with probability 1) 90 People usually use the word “risk” to describe a potential for loss. This is not necessarily the case in finance terminology: RG has no potential for loss, but is still risky, because it is unpredictable. On the other hand, SB is not risky, because it is perfectly certain: you lose $10 with certainty. Of course, investor’s cause of
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This note was uploaded on 02/17/2009 for the course FIN FIN 221 taught by Professor Jochec during the Summer '08 term at University of Illinois at Urbana–Champaign.

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Conflict of interest between shareholders and bondholders_Marek

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