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

A leveraged company is close to financial distress. Its shareholders, who hold limited-liability equity, push management to undertake a very risky project with a negative expected net present value but a small chance of a large payoff. The conflict illustrated is most likely between:

The conflict is between shareholders and creditors. Near distress, limited-liability equity holders keep the upside of a risky project while creditors bear much of the downside, so owners may favor value-destroying risk shifting that transfers wealth away from lenders.

  1. Ashareholders and creditors, because equity holders may gain from risk shifting at creditors' expenseCorrect
  2. Bmanagers and employees, because wages would be cut to fund the project
  3. Cshareholders and regulators, because the project would breach exchange listing rules

Explanation

Equity is like a call option: owners capture the large upside while creditors bear much of the downside near distress. This asset substitution or risk shifting is a shareholder-creditor conflict. Nothing in the stem concerns wages or listing rules.

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