In a company, an agency problem may exist between management and shareholders on one hand and the debt holders (creditors and lenders) on the other because management and shareholders, who own and control the company have the incentive to enter into transactions that may transfer wealth from debt holders to shareholders. Hence the need for agreements debt holders in lending contracts.
(a) State and explain any four actions or transactions management and shareholders that could be harmful to the interests of debt holders (sources of conflict).
(b) Write short notes on any four restrictive covenants that debt holders may use to protect their wealth from management and shareholder raids.
(i)Borrowing additional debt capital which take priority charge in case of liquidation.
(ii) Disposal of assets used as collateral for loans
(iii) Payment of high dividends which reduce the cash for investment.
(iv) Asset substitution
If a firm sells bonds for the stated purposes of engaging in low variance projects, the value of the shareholders equity rises and the value of bondholders claim is reduced substituting projects which increase the time variance rate.
(v) Under investment
A firm with outstanding bonds can have incentive to reject projects which have a positive NPV if the benefit form accepting the project accrues to the bondholders.
Sale of assets used to secure creditors
(b) Restructure bond covenants include the following:
(i) Restriction on investments, flats profits movement in such risky ventures. The aim to discourage assets substitution.
(ii) Restriction to disposition of assets require that the firm should not dispose of substantial part of its properties and assets.
(iii) Securing debts give bondholders title to pledge bonds until assets are paid.
(iv) Restrictions on mergers. Mergers may affect the value of claims.
(v) Covenants restricting payments of dividends a limit in distribution is placed.
(vi) Covenants restricting subsequent financing restrict issue of additional debt
(vii) Covenants modifying pattern of payment to bondholder
• Sinking fund
• Convertibility provisions
• Collability provisions
(viii) Bonding requirement
• Purchase of insurance
• Certificates of compliance
• Specification of accounting technique.