Question

What is the primary reason conflicts may arise between stockholders and debt holders?

a) Stockholders are less willing than debt holders to take on risky projects due to their higher susceptibility to investment losses.
b) Debt holders are less willing than stockholders to take on risky projects due to their higher susceptibility to investment losses.
c) Stockholders and debt holders are equally willing to take on risky projects, minimizing conflicts.
d) Conflicts between stockholders and debt holders are unrelated to their willingness to take on risky projects.

Answer 1

Conflicts may arise between stockholders and debt holders because debt holders prefer less risky projects to ensure they receive consistent interest payments, while stockholders might favor riskier projects that could offer higher returns.

Step-by-step explanation:

The primary reason conflicts may arise between stockholders and debt holders is b) Debt holders are less willing than stockholders to take on risky projects due to their higher susceptibility to investment losses. While stockholders may benefit from the potential high returns of risky projects (with their losses limited to their investment), debt holders are interested in the firm's ability to make consistent interest payments, and risky projects could jeopardize that stability. In a case of financial distress, stockholders might favor riskier projects that could lead to higher returns, whereas debt holders would prefer more conservative actions to ensure they receive their scheduled interest payments and principal repayment.