Which one of these best describes the relationship between bondholders and stockholders at a time when it appears the firm may be facing increased financial distress?
A)Stockholders have an incentive to underinvest in new projects to the detriment of bondholders.
B)Both parties tend to work together for the common good of the firm.
C)Both bondholders and stockholders will encourage the firm to take on new high risk projects.
D)Bondholders will tend to lower their required rate of interest so the firm can afford additional financing until its financial status improves.
E)Bondholders tend to milk the property at the expense of stockholders.

Question

Quizplus · Accepted Answer

When a firm is facing increased financial distress, bondholders are more concerned about getting their money back than making a profit. Thus, they prefer conservative financial decisions and may push for reduced investment in new projects. On the other hand, stockholders are incentivized to take on more risk to generate higher profits, which may not be in the best interest of bondholders. This creates a conflict of interest between the two parties, and stockholders may prioritize their interests over bondholders, leading to underinvestment in the long run.

Which One of These Best Describes the Relationship Between Bondholders