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CMA Intermediate · Financial Management and Business Data Analytics · Introduction to Financial Management

Under which situation is an agency conflict between shareholders and debenture holders most likely to arise?

A conflict arises when the firm uses borrowed funds for much riskier projects than lenders expected. Shareholders capture the upside while debenture holders, who earn only fixed interest, bear the extra risk of default. Timely payments and stable leverage do not create such a conflict.

  1. AThe firm uses debenture funds to take on much riskier projects than those the lenders assumed when lendingCorrect
  2. BThe firm repays debentures exactly on the due date
  3. CThe firm pays interest regularly to debenture holders
  4. DThe firm keeps its debt-equity ratio unchanged after the issue

Explanation

Shareholders gain from high returns on risky projects while lenders bear the downside with fixed returns, so shifting to riskier projects after borrowing transfers wealth from lenders. Timely interest, timely repayment and an unchanged debt-equity ratio honour lenders' expectations and cause no conflict.

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