Question

Bedrock Company’s manager must choose how to allocate funds for next year capital expenditure. She has two projects in front of her: Investment L has low risks but a lower payoff; Investment H has high risks and a higher payoff. What project should she choose and why? Which project would stockholders most likely prefer? Debtholders? What actions can debtholders take to protect their interests?

Answer 1

She can choose high risk project if she wants to make stockholders happy, high risk, high gain. Initially risk will be higher but in future, it will provide higher benefits.

Stockholders prefer high risk project because, high risk project yields high return and when company will grow, its share price will grow, that will give capital appreciation to the stockholders. They also get dividend out of the company's net profit, so they are most likely to prefer riskier projects.

On the other hand, debtholders will prefer less risky project because they want fixed interest payment, they do not want any upside. They are concerned about the use of additional debt.

Debtholders can take actions to protect themselves by including covenants in the bond agreement that can protect themselves by limiting use of more debt.