2. In the context of a firm’s capital structure, when does a firm has an incentive to (i) take large risks and (ii) make underinvestment?
Explain the mechanism/process.
Ans:
Incentive for taking an excessive risk:
A project with high risk always gives high returns but sometimes it may be the opposite. At that times organizations like Proprietary Concerns bear all the risk/loss. When it comes to firms, they work on behalf of shareholders. Shareholders are the real owners of the firm. When the firm incurs losses, the payout will be stopped to the equity shareholders and in extreme situations like bankruptcy, if capital structure consists of debt holders the burden is shifted to debt holders. Interest and principal payment will be curtailed. Most affected will be the debt holders cuz equity holders mainly yield on capital gains when they sell the shares rather than on dividends. Equity holders will be affected if they don't go out by selling their shares before the price of the shares starts falling drastically. The entire burden will be borne by the debt holders because their payment will be stopped.
Incentive for making under investment:
This will be a theoretic incentive because firms operate to earn profits for themselves and they don't always run the business by keeping debtholders in their perspective.
If a firm invests more and things don't turn out good, the firm goes into bankruptcy. As per code(depends on the laws of the country) debtholders are put first for the payment in the event of bankruptcy. Therefore if the firm has high investments, all the converted money will be used to clear debtholders' claims first.
This may seem as the opposite when compared to first. Debtholders will be and can be paid only if the firm has money. Money includes everything which can be converted into money.
*Debtholders include creditors and everyone to whom fixed payment has to be made.
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