Tuesday, March 2, 2010


Creditors’ Claims and opportunities

In practice, both shareholders and creditors supply funds to finance a firm’s investment projects. Investors hold different claims on the firm’s assets and cash flows, and thus, they are exposed to different degrees of risk.

Creditors have a priority claim over the firm’s assets and cash flows. The firm is under a legal obligation to pay interest and repay principal. Debt holders are, however, exposed to the risk default. Since the firm’s cash flows are uncertain, there is a probability that it may default on its obligation to pay interest and principle.

Preference shareholders hold claim prior to ordinary shareholders but after debt holders. Preference dividend is fixed and known, and the firm will pay it after paying interest but before paying any ordinary dividend. Because preference dividend is subordinated to interest, preference capital is more risky than debt.

Ordinary shareholders supply capital either in the form of retained earnings or by purchasing new shares. Unlike creditors, they are owners of the firm and retain its control. They delegate powers to management to make investment decisions on their behalf in such a way that their wealth is maximized. However, ordinary shareholders have claim on the residual assets and cash flows. The payment of ordinary dividend is discretionary.

Ordinary shareholders may be paid dividends from cash remaining after interest and preference dividends have been paid. Also, the market price of ordinary share fluctuates more widely than that of the preference share and debt.

Thus, ordinary share is more risky than both preference share and debt. Various forms of corporate debt can also be distinguished in terms of their differential riskiness. If we compare corporate bonds and government bonds, the later are less risky since it is very unlikely that the government will default in its obligation to pay interest and principal.

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