Competing Stakeholder Interest in Capital Structure Decisions

Capital structure decisions impact stakeholder groups differently. Increased leverage increases the risk to all stakeholders but only results in a higher return for shareholders.

Debt vs. Equity Conflict

Debtholders have a contractual and prior claim to cash flows and firm assets over shareholders. Their potential return is limited. Equity holders have more downside risk but a much higher upside potential. Therefore, debt holders will prefer lower leverage levels. On the other hand, equity holders will prefer higher leverage levels that offer them greater return potential.

Other Debt Considerations

Seniority and Security

In case of default, secured debt lenders are likely to recover more than unsecured lenders. Likewise, senior debt is likely to recover more than subordinated debt. Consequently, secured and senior debt lenders can tolerate management actions that increase leverage.

Long-term vs. Short-term debt

Debtors are exposed to probable changes in a business environment, strategy, and management conduct as time passes.

Safeguard for Debtholders

• Debt covenants can limit the amount of debt a company can take and limit management actions that increase the risk to debt holders. Positive covenants state what borrowers must do, while negative covenants state what borrowers cannot do.
• Companies want to keep their credit access and conditions favorable. For this reason, they’ll take steps to retain or improve their creditworthiness if they need to borrow in the future.
• Financial distress costs can be substantial.

Preferred Shareholders

Preferred shares have debt and equity-like characteristics. They are ranked ahead of common shareholders but after debt holders in terms of security and priority of dividend payments. Failure of a company to pay preferred shareholders dividends is not considered a default. However, it prevents payment of dividends to common shareholders until preferred shares dividends are paid. Issuing preferred shares is less risky to a company’s debt holders and equity holders than issuing debt.

Preferred shareholders are vulnerable to management’s actions that increase financial leverage and risk. This is because they lack the covenant protection that debt holders may have.

Management and Directors

Management and directors are hired to maximize shareholder wealth resulting in the debt/equity conflict. Good compensation should align interests between managers/directors and shareholders.

Question

Which of the following tools are most likely used by debt holders to align a company’s interest to debt holders’ interests?

1. Compensation.
2. Debt covenants.
3. Equity ownership.

Solution

The correct answer is B

Debt covenants are lending agreements between lenders and the borrowing company that are used to align the interest of both parties.

A is incorrect. Compensation aligns the interests between management, directors, and shareholders.

C is incorrect. Equity ownership aligns individuals’ incentives to the interests of a company. It also encourages everyone involved to think long-term, which is key to a company’s success.