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 faces financial distress, bondholders have a higher priority of claim than stockholders. As a result, they are likely to encourage the firm to undertake more conservative financial decisions and prioritize paying off the debt. Stockholders, on the other hand, may have an incentive to undertake risky projects to increase their return on investment, even if it puts the company's financial stability at risk. Therefore, stockholders may underinvest in new projects, which can be detrimental to bondholders.

Which One of These Best Describes the Relationship Between Bondholders