Question

You have been given the following information:

I) no action by debtholders since these are equity holders’ concerns;

II) increasing the agency costs, and therefore, bondholders act on various restrictions and covenants, which will diminish firm value;

III) investments of the same risk class that the firm is in

Choose the most correct answer related to “When shareholders pursue strategies such as taking excessive risks or paying excessive dividends, these will result in”.

Select one:

a. I only

b. II only

c. III only

d. I and III only

e. None of these above

Answer 1

When a firm is taking too much risk or paying excessive dividends, then it is the debtholders or banks which have given loan that stand to lose. If the company loses money on extra risky projects or pays out excessive money it means it has less money to pay back debt holders. The risk of debt holders increases and they would not want to increase the risk for themselves. As a result they put certain conditions on how much dividend can be paid out or how much risky projects can be undertaken. These conditions or covenants have to be accepted by the company or else raising debt will be very difficult for it. These conditions raises conflicts and the cost associated with this is known as agency costs and will therefore reduce firm value. Hence option is b. II only.