Conflict Between Stockholders & Bondholders

High-risk Projects

Shareholders promote those projects that offer higher incentives and thus are accompanied by high risks. The higher risk values increase the needed return on the company's debt. As a result, the value of outstanding bonds is affected. If the outcome of a project is positive, shareholders earn the extra profits while bondholders get their fixed returns. However, in an eventuality of losses, both shareholders and bondholders must contribute. Consequently, to secure their investment, bondholders favor projects involving limited risk. Project selection thus leads to disagreement between both parties.

Low-risk Projects

A low-risk project is accompanied by lower return on investment. Bondholders are in favor of such investments with positive net present value. From a shareholder's perspective, the proportionate gains accruing to bondholders are high, and thus it is not a lucrative opportunity. Companies are often tempted to forgo such projects and thus win shareholder's trust. Underinvestment problems thus are another critical cause of conflict between shareholders and bondholders.

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Spin-off
Corporate divestiture for creation of a new entity via the issue of new shares is another situation leading to conflict between stockholders and bondholders. Management can transfer wealth to existent or new shareholders by issuing fresh debt. The firm's financial risk increases, and the bond value gets reduced. In fact, to tempt shareholders, companies explain wealth transfer gains during the spin-off announcements. Typically during the announcement months, bondholders receive negative returns on their investment. The bondholder's claim to wealth gets diluted in favor of a shareholder.

High Dividend Payments

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A firm has the option of paying high dividends to shareholders. However, while shareholders would be in favor of such a situation, the resultant reduced cash flows are not a healthy sign for a bondholder. An extreme situation is where the company pays all of its assets as dividends. In this case it avoids paying debts.
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Agency cost refers to the cost incurred by a firm because of the problems associated with the different interests of management and shareholder and the information asymmetry that exists between the principal (shareholders) and the agent (management). Agency Cost of Equity The agency cost of equity arises because of the difference in interests between the shareholders and the management. As long as the managements interests diverge from that of the shareholders, the shareholders will have to bear this cost. Management may be tempted to take suboptimal decisions that may not work towards maximizing the value for the firm. Any measures implemented to oversee and prevent this will have a cost associated with it. So, the agency costs will include both, the cost due to the suboptimal decision, and the cost incurred in monitoring the management to prevent them from taking these decisions. Agency Cost of Debt The agency cost of debt arises because of different interests of shareholders and debt-holders. Assume that the management is in favour of the shareholders. If so, the management can in many ways transfer the wealth to the shareholders and leaving debt-holders empty handed. Anticipating such activities, the debt-holders will take various preventive measures to disallow management from doing so. The debt holders may do so in the form of higher interest rates to protect themselves from the losses. Alternatively they may impose restrictive covenants. One example of such behaviour is seen in the priority given to dividends. In their pursuit to please the shareholders, the management may give cash dividends to the shareholders, leaving very less to pay to the debt holders. To avoid this situation, there is this requirement that the interest must be paid before dividends. Similarly there are other situations where such covenants are placed, for example, debts with different seniority. Information Asymmetry In general, we can say that the management is more information about the prospects of the business compared to shareholders, debt-holders and other parties. This is called information asymmetry.

The information asymmetry directly affects the agency costs: the higher the information asymmetry, the greater will be the agency costs.