Question

Suppose your company raises funds by issuing bonds.

1. Why would there be an agency conflict between borrowers and lenders?
2. How could the shareholders increase their prospective returns to the detriment of the bondholder’s investment?
3. How might bondholders respond to the threat of such behavior ex ante? Be sure to include all the avenues that the bondholders might take to reduce these potential costs (the exception is they cannot back out of the funding deal).

Answer 1

A) An agency conflict occurs between the borrow and the lender because the borrower makes decisions after the loan is made that affect the lender's welfare. For example, the borrower could invest in risky projects or take on additional debt.

B) A Company Borrows Money to Expand Bondholders, on the other hand, may face a decline in the value of their investment as the company's perceived risk increases as a result of its increased debt load. Risk increases, in part, because the debt could make it harder for the company to pay its obligation to bondholders.

C) However, investors need to be aware of some potential pitfalls and risks to. To do this, they will scoop up existing bonds that pay a higher interest rate, investors would naturally jettison bonds that pay lower interest rates