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

A firm's management proposes to replace its safe core operations with a much riskier project that has a higher expected payoff but greater variability. Which stakeholder group is most likely to object, and why?

Bondholders are most likely to object. Their claim is fixed, so they do not share in extra upside from a riskier project, yet they bear a higher chance of default and lower recovery. Shareholders may favor the risk because they keep the upside while their downside is limited.

  1. ABondholders, because the added risk raises default probability without increasing their fixed claimCorrect
  2. BShareholders, because the project lowers the value of their limited liability
  3. CCustomers, because the project changes the prices of existing products

Explanation

Creditors receive fixed interest and principal, so they gain none of the upside from a riskier project but suffer if default becomes more likely. Shareholders, with a residual claim, may benefit from the upside and limited liability, so they are less likely to object.

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