Question

How can shareholders take wealth from bondholders through their a) investment, b) financing and c) dividend decisions? d) How can bondholders protect themselves?

Answer 1

Share holders are the investors who contributed to the equity of a company in form of shares

Bond holders are the the investors who lend money to a company for interest over a specified period

Shareholders are interested in the strategic growth of the business where as bond holders are only interested in the return on their debt to the company and their principal outstanding.

Share holders take wealth from bond holders through the all three following ways

a) Investments - Share holders has the absolute right to invest into a new business or expand existing business through new investments. A new investment is always riskier any wrong decision can impact the bond holders. So Bond holders can protect themselves by restricting investment policy.

b) Financing - shareholders can influence the wealth of bond holders through Leverage buy outs (LBO) which is a type of aquisition in which a new company is entirely aquired through debt which increases the levearge of the commpany and new bond holders will be given equal priority on the company's assets along with the existing bond holders. This can be countered by the bond holders through inserting a clause in the agreement where in bond holders have right to sell back bonds to the company when their interests are being affected

c) Increase in dividend pay outs will reduce the value of the firms assets which reduces the ability of the company to pay its bond holders. Bond holders can counter this risk by constraining the dividend policy.