Question

The agency conflict between stockholders and creditors can be reduced in several ways. Which of the following does not reduce agency conflict between stockholders and creditors?
a. Prevent the company from issuing stock options
b. Writing detailed debt covenants
c. Creditors charging a higher rate
d. Prevent the company from increasing its debt ratios beyond a specified level
e. Prevent the company from paying dividends unless profits are above a certain level

Answer 1

Answer:

a) Prevent the company from issuing stock options

Explanation:

The agency conflict between stockholders and creditors is similar to the agency problem between management and shareholders, where managers act in their own interest instead of that of the shareholders. In the case of creditors, they provide finance for the company in the form of debt but there are certain conditions that were prevalent at the time of providing debt finance. The problem happens when shareholders after collecting debt engage in riskier projects than has been anticipated by creditors, which could cause losses for the creditors if those risks should materialize.

With the above understanding, it is obvious that such agency conflict could not be reduced by preventing the company from issuing stock options to its employees. Rather such stock options will potentially reduce the debt ratio in the future when they become equity, as equity becomes bigger in the capital structure in relation to debt.