CFA Level I · CFA Level I Exam · Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
A company with significant debt is considering replacing a low-risk project with a much riskier one that has a higher potential payoff. Shareholders favor the change. The conflict between shareholders and creditors is most likely because the riskier project:
The riskier project may transfer value from creditors to shareholders. Creditors receive fixed claims and gain nothing from the higher potential payoff, but they face greater default risk, while shareholders capture the upside. This is a classic shareholder-creditor conflict.
- Alowers the firm's cost of equity only
- Bmay transfer value from creditors to shareholdersCorrect
- Cguarantees higher interest payments to creditors
Explanation
Shareholders keep upside gains while creditors' claims are fixed, yet creditors bear more default risk. Value can therefore shift from creditors to shareholders. Creditors are not guaranteed more interest, and the cost of equity does not fall.
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