Conflict Between Shareholders and Creditors

What kind of agency conflict between share holders and creditors may exist?

Conflict between shareholders and creditors is common for the company which use debt capital to form an optimum capital structure. Agency relation exist when one party works as an agent of the principal. In an organization management works as a agent of owner or share holders. When managers work for the company they can be influenced by the own interest so that they prefer their own interest rather than the interest of the company, on the other hand creditors interest is to provide credit and get the principal amount and interest timely. For ensuring their credit return creditor always concerned whether the company is doing business in the right manner or not. By monitoring the financial performance of the company creditors actually want to ensure their interest. So if there is any dispersion then creditors works to resolve the issue by taking necessary steps.

Conflict between Shareholders and creditors

Conflict between Shareholders & Creditors

Creditors have a claim on part of the firm’s earnings stream as well as a claim on the firm’s assets in the event of bankruptcy. However, the stockholders have control through the firm’s managers of the decision that affect the profitability and risk of the firm. Creditors lend funds at an specific rate which is based on the several factors. These are:

  1. On the riskiness of the firm’s existing assets,
  2. On expectations concerning the riskiness of future asset additions,
  3. On the firm’s existing capital structure (that is, the amount of debt financing used), and
  4. On expectations concerning future capital structure decision.

These are the primary determinants of the riskiness of a firm’s cash flows and hence its debt, so creditors base their required rates of return on these factors.

 Now suppose the stockholders, acting through management, have the firm take on a large new project that has a greater risk than was anticipated by creditors. This increased risk will cause the required rate of return on the firm’s debt to increase, which in turn will cause the value of the outstanding debt to fall. If the risky capital investment is successful, all of the benefits will go to the firm’s stockholders, because creditors’ returns are fixed at the old, low-risk rate. However, if the project is unsuccessful, the bondholders will have to share in the losses.

Written by

Md. Nahian Mahmud Shaikat

Student of MBA

Institute of Business Administration (IBA)

Jahangirnagar University

Email: [email protected]

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