Question

2. Stockholders can transfer wealth from bondholders through a variety of actions. How would the following actions by stockholders transfer wealth from bondholders?

• a. An increase in dividends
• b. A leveraged buyout
• c. Acquiring a risky business
• How would bondholders protect themselves against these actions?

3) There are some corporate strategists who have suggested that firms focus on maximizing market share rather than market prices. When might this strategy work, and when might it fail?

4) It is often argued that managers, when asked to maximize stock price, have to choose between being socially responsible and carrying out their fiduciary duty. Do you agree? Can you provide an example where social responsibility and firm value maximization go hand in hand?

Answer 1

(a) An increase in dividends: Make existing debt riskier and reduce its value. Bondholders can protect themselves by constraining dividend policy.
(b) A leveraged buyout: If the existing debt is not refinanced at the "new" interest rate, existing bondholders will find the value of their holdings are lower after the LBO. Bondholders can protect themselves by inserting protective puts into their debt, allowing them to put the bonds back to the firm and receive face value.
(c) Acquiring a risky business: If a risky business is acquired, existing bondholders may find themselves worse off since the underlying debt is now riskier. Bondholders can protect themselves by restricting investment policy.

Bondholders could protect themselves against such actions by inserting covenants into the bond contract controlling and limiting the ability of stockholders to take such actions.