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CFA Level I · CFA Level I Exam · Organizational Forms, Corporate Issuer Features, and Ownership

A highly leveraged firm's shareholders approve a plan to replace a low-risk project with a much riskier project that has the same expected value. Relative to the original plan, the change most likely:

The riskier project most likely benefits shareholders at creditors' expense. Equity behaves like a call option, gaining from higher variability, while creditors receive fixed claims and bear greater default risk. With unchanged expected value, wealth shifts from creditors to shareholders, a shareholder–creditor conflict.

  1. Atransfers wealth from shareholders to creditors
  2. Bbenefits shareholders at the expense of creditorsCorrect
  3. Cbenefits creditors through a higher expected recovery

Explanation

Shareholders' equity resembles a call option, so higher risk raises its value, while creditors have capped upside and greater downside risk. With equal expected firm value, wealth shifts from creditors to shareholders. The first option states the opposite direction.

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