Question

Explain how the prospect of risk shifting can create a conflict between debt holders and equity
holders.(would appreciate if you can post answers by writing down the words on web page instead of pictures in case i cannot look clearly of each words)

Answer 1

Risk Shifting is also known as asset substitution. When managers make risky investment decisions which maximize shareholder value at the expense of debtholder’s interest, risk shifting arises.

Since management is by the Board of Directors who are in turn elected by shareholders, they act in the best interest of shareholders. Equity holders have control over the type of investments the firm chooses. Debtholders only provide funds but shareholders make decisions.

Shareholders are paid when things go well in a firm, whereas debt holders have to bear the costs if things go wrong. Risk shifting behaviour can be found in distressed firms and volatile market. Increase in volatility and investing in a risky project provides the shareholders an opportunity to increase value by investing. Shareholders try to increase the value of share price at the expense of debt holders. Risk shifting also arises in firms where shareholders’ and managers’ interests are aligned.

Risk shifting is associated with the incentive and ability of shareholders to shift additional firm risk to debtholders. Investment in volatility periods is considered to reduce the value of debt in distressed firms.

High levered firms bear extremely high costs of debt financing because debt investors take a premium to outweigh the negative consequences of risk-shifting incentives.

Issuing of short-term debt can reduce risk-shifting incentives because short-term debt is less sensitive to volatility. Firms with more growth options use short term debt in capital structure.