Lesson 3 of 7 · 13 min

Payoffs and conflicts between lenders and shareholders

Lenders' upside is capped at what they are owed while shareholders keep everything above it, so shareholders like risk and payouts that lenders dislike, and lenders respond with contract restrictions.

In short

  • If firm value VV exceeds debt DD (solvent), shareholders get V−DV - D and debtholders get DD in full.
  • If V<DV < D (insolvent), shareholders get nothing and debtholders take control and recover what they can.
  • Both payoffs are asymmetric; both groups' maximum loss is their initial investment.
  • Shareholders favour riskier projects, more leverage and higher dividends; lenders favour safer projects and cash-flow certainty.
  • Lenders protect themselves with covenants such as minimum debt-service coverage and leverage caps.

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Payoffs and conflicts between lenders and shareholders · Investors and Other Stakeholders