Agency Problem between Shareholders and Creditors
➦ Agency problem is the conflict of interest between the shareholders and managers, and shareholders and creditors. It may cause difficulty in achieving the goal of shareholder’s wealth maximization.
➦ In the agency problem, Creditors are viewed as principal and the shareholders as the agent .There is conflict of interests between shareholders, through managers, and creditors.
➦ Conflict of interests between shareholders and creditors arises when the managers make decisions for shareholders value by ignoring the interest of creditors.
➦ Since, Creditors provide their capital to the firm at fixed rate of interest for specified period and the firm is authorized to use it for a given time period according to the agreed terms and conditions.
➦ Both shareholders and creditors have claim on assets and earnings of the company. Creditors get priority for receiving their interest and principal repayment.
➦ However, creditors invest their capital to earn a fixed rate of interest and to get the principal paid back upon maturity. Shareholders invest their capital to maximize the market price of their shares.
➦ Creditors are concerned to see the earnings sufficient to cover their fixed interest payment and principal repayment in time. Creditors do not entitle to the extra return from additional risk, but they have to bear the additional risk taken by the company. So, they oppose the high risk.
➦ For example, the managers may decide to invest in a highly risky project. If such a risky project becomes successful, all the benefits go to the shareholders because the creditor will receive only the already fixed rate of return.
➦ However, if the project is unsuccessful, creditors may have to sustain the losses. The managers may repurchase the firm’s outstanding stock by borrowing additional funds to increase the leverage situation.
➦ In such a situation also all the benefits go to the stockholders at the cost of increased risk to the creditors. Thus ,there is conflict of interests between shareholders and creditors.
➦ For instance, imagine a publicly traded company where the shareholders, who own equity in the company, want to see higher returns on their investments.
➦ To achieve this, the shareholders may pressure the company’s management to pursue aggressive expansion strategies or undertake projects with high potential returns but also high levels of risk.
