Question

Briefly explain about the "wealth transfer" from debtholders to shareholders in a firm with a high level of information asymmetry and a high level of debts. [Instruction: Write about ten lines in total.]

Answer 1

The cost of the agency's debt arises due to the different interests of the shareholders and the debt holders. Suppose management is in favor of the shareholders. If so, management can transfer wealth to shareholders in many ways and leave debtors empty-handed. In anticipation of such activities, debt holders will take various preventive measures to prevent management from doing so. Debt holders can do this in the form of higher interest rates to protect themselves from losses. Alternatively, they can impose restrictive covenants.

An example of such behavior is seen in the priority given to dividends. In its quest to please shareholders, management can give cash dividends to shareholders, leaving very little to pay debt holders. To avoid this situation, there is a requirement that interest must be paid before dividends.