Question

As a result of a recession, Yellowstone corporation is in financial distress.   Which one of the following best characterizes the likely interaction between bondholders and shareholders of Yellowstone?

a) Both bondholders and shareholders will encourage the firm to take on new high risk projects.

b) Bondholders reduce their required rate of interest so the firm can obtain additional financing until its financial status improves.

c) Bondholders tend to milk the property at the expense of stockholders.

d) Shareholders have an incentive to underinvest in positive NPV projects to the detriment of bondholders.

• Both bondholders and shareholders tend to work together for the common good of the firm.

Answer 1

Option B is the likely scenario.

Option A. Unlikely, because by taking high risk projects firm may further fall into deep trouble and may fall into bankruptcy.

Option B. Likely, as reducing some fixed charge (interest) till firm's financial status improves will lead to its financial health back on track. Also stockholders must have sacrificed their returns due to financial distress therefore sharing the burden of financial distress will do good for firm.

Option C. Unlikely, as in financial distress value of firm's asset fall significantly and therefore milking firm's asset will do more harm than good.

Option D. Unlikely, underinvest in positive NPV contracts will make firm's financial position worse, which is not in favour of anyone.

Option E. Unlikely, as this status is quite vague in terms of satisfying anyone's objective.

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