(149)---RISK DIFFERENCES IN SHAREHOLDERS AND CREDITORS CLAIMS

Risk Differences in Shareholders’ and Creditors’ Claims

Investors will require different rates of return on various securities since they have risk differences. Higher the risk of a security, the higher the rate of return demanded by investors. Since ordinary share is most risky, investors will require highest rate of return on their investment in ordinary shares. Preference share is more risky than debt; therefore, its required rate of return will be higher than that debt. The risk return relationship for various securities is shown in above figure,

It may be observed in the figure that the required rate of any security is composed of two rates a risk free rate and risk premium. A risk free will require compensation for time value and its risk premium will be zero. Government securities, such as the treasury bills and bonds, are examples of the risk free securities. Investors expect higher rates of return on risky securities. The higher then risk of a security, the higher will be its risk premium, and therefore, a higher required rate of return.

Since the firm sells various securities to investors to raise capital for financing investment projects, it is necessary that investment projects to be undertaken by the firm should generate at least sufficient net cash flow to pay investors’ shareholders and debt holders their required rates of return. In fact, investment projects should yield more cash flows than to just satisfy the investors’ expectations in order to make a net contribution to the wealth of ordinary shareholders.

Viewed from all investor’s point of view, the firm’s cost of capital is the rate of return required by them for supplying capital for financing the firm’s investment projects by purchasing various securities. It may be emphasized that the rate of return required by all investors will be an overall rate of return a weighted rate of return. Thus, the firm’s cost of capital is the “average” of the opportunity costs of various securities, which have claims on the firm’s assets. This rate reflects both the business risk and financial risk resulting from debt capital. Recall that the cost of capital of an all equity financed firm is simply equal to the ordinary shareholders’ required rate of return, which reflects only the business risk.

(148)---CREDITORS CLAIMS AND OPPERTUNITIES

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.