The Source of the Conflict

The source of the conflict of interest between stockholders and bondholders lies in the differences in the nature of the cash flow claims of the two groups. Bondholders generally have first claim on cash flows, but receive fixed interest payments, assuming that the firm makes enough income to meet its debt obligations. Equity investors have a claim on the cashflows that are left over, but have the option in publicly traded firms of declaring bankruptcy if the firm has insufficient cash flows to meet its financial

14 Karpoff, J.M. and P.H. Malatesta, 1990, The Wealth Effects of Second-Generation State Takeover Legislation, Journal of Financial Economics, v25, 291-322.

15 Bhagat, Sanjai & Bernard Black. 1999. The Uncertain Relationship Between Board Composition and Firm Performance. Business Lawyer. v54, 921-963.

obligations. Bondholders do not get to participate on the upside if the projects succeed, but bear a significant portion of the cost, if they fail. As a consequence, bondholders tend to view the risk in investments much more negatively than stockholders. There are many issues on which stockholders and bondholders are likely to disagree.

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