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CFA Level I · CFA Level I Exam · Investors and Other Stakeholders

A company is nearing financial distress. Its equity is worth little, and management, acting for shareholders, is considering a high-risk project with a small chance of a large payoff and a high chance of loss. Which party is most likely to be harmed by this decision, and why?

Creditors are most likely harmed, because they bear the downside without sharing the upside. Near distress, shareholders have little to lose, so a risky project shifts risk to creditors: their claim is fixed, so success does not raise their payoff, but failure reduces their recovery.

  1. AShareholders, because limited liability magnifies their losses
  2. BCreditors, because they bear the downside without sharing the upsideCorrect
  3. CManagers, because their bonuses decline when risk rises

Explanation

Near distress, shareholders have little to lose and much to gain from a risky gamble, a form of risk shifting. If it succeeds, shareholders gain; if it fails, creditors absorb the loss because their claim is fixed and senior. Shareholders' losses are capped by limited liability, so they are not the ones harmed.

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