M2: Investors and Other Stakeholders

What is the fundamental difference between debt and equity claims?

Debt is a finite, priority contractual claim with promised interest and principal; equity is permanent capital with a residual claim after priority claims are satisfied.

What is the maturity of debt versus equity?

Debt has a finite maturity; equity has an indefinite life and represents permanent capital.

What return do debtholders expect?

Contractually promised interest and repayment of principal.

What return do shareholders receive?

Dividends when declared plus potential capital appreciation; their upside is not contractually capped.

What is a priority claim?

A claim that must be satisfied before lower-ranking claims receive payment.

What is a residual claim?

The right to receive whatever remains after all higher-priority claims have been satisfied; ordinary shareholders are residual claimants.

Who has voting rights: shareholders or bondholders?

Shareholders generally have voting rights; bondholders generally do not.

How do bondholders protect themselves if they do not have voting rights?

Through contractual covenants that restrict issuer behaviour and protect lenders.

★ EXAM: What substitutes for shareholder voting rights for bondholders?

Covenants. Bondholders have no voting rights, so contractual restrictions are their primary means of controlling issuer behaviour.

What is the liquidation priority from highest to lowest?

Secured debt > senior unsecured debt > subordinated debt > junior subordinated debt > preference shares > ordinary shares.

★ EXAM: What is the key rule when ranking debt versus equity?

All debt ranks ahead of all equity, regardless of the specific class.

Within secured debt, which ranks higher: first-lien or second-lien debt?

First-lien debt ranks above second-lien debt with respect to the pledged collateral.

Why does secured debt generally have lower credit risk?

It has a specific claim on pledged collateral, increasing expected recovery if the issuer defaults.

What is the general relationship between seniority and required yield?

Higher seniority generally means lower credit risk and therefore a lower required yield, all else equal.

★ EXAM: Which generally has the lowest credit risk and yield among debt classes?

Senior secured debt.

What is senior unsecured debt?

Debt without pledged collateral that ranks above subordinated debt.

★ EXAM: Which debt class is the benchmark for issuer credit ratings in this curriculum?

Senior unsecured debt; specific issues may be adjusted for their seniority and security.

What is subordinated debt?

Debt contractually ranked below senior unsecured debt but above junior subordinated debt and all equity.

★ EXAM: Does subordinated debt rank above preference shares?

Yes. All debt, including subordinated and junior subordinated debt, ranks above preference and ordinary equity.

What is junior subordinated debt?

Debt ranking below subordinated debt but still above all equity claims.

⚠ WATCH FOR: How should you approach liquidation-ranking questions?

Anchor on secured vs unsecured and senior vs subordinated; then remember preference shares rank above ordinary shares but below all debt.

What are preference shares?

Equity securities that typically pay a fixed dividend and rank above ordinary shares but below every class of debt.

What are cumulative preference shares?

Preference shares whose unpaid dividends accumulate as arrears and must be paid before ordinary shareholders can receive dividends.

What are non-cumulative preference shares?

Preference shares for which a skipped dividend is permanently lost; the holder has no future claim to that missed payment.

★ EXAM: Which requires a higher yield, cumulative or non-cumulative preference shares, all else equal?

Non-cumulative preference shares, because the holder has less protection when dividends are skipped.

Are preference dividends guaranteed?

No. Preference shareholders have priority over ordinary shareholders when distributions are made, but dividends are not contractual obligations like debt interest.

⚠ WATCH FOR: What does cumulative preference stock actually guarantee?

Skipped dividends accumulate and must be cleared before ordinary dividends; it does not guarantee that dividends will be paid on time.

How are debt interest and equity dividends treated for issuer taxes?

Debt interest is generally tax-deductible; dividends are not tax-deductible.

Why is debt generally less costly than equity for an issuer?

Debt has a priority, fixed and finite claim and generally receives favourable tax treatment through interest deductibility.

Why is debt riskier than equity from the issuer's perspective?

Debt creates mandatory interest/principal obligations and covenants; failure to meet obligations can lead to financial distress or bankruptcy.

What is the debtholder's upside?

Capped at the promised interest and principal.

What is the shareholder's upside?

Potentially unlimited because shareholders receive the residual increase in firm value after debt claims.

What happens if firm value V exceeds debt D?

Debtholders receive their promised claim and shareholders receive the residual V − D.

What happens if firm value V is below debt D?

Shareholders receive zero; debtholders take the remaining assets but may recover less than promised.

Why do shareholders generally prefer more risk than bondholders?

Shareholders capture the upside above the debt claim while limited liability caps their downside at their investment; bondholders have capped upside but can suffer losses from default.

What is financial leverage?

The use of debt financing relative to equity financing.

How does financial leverage affect ROE?

It magnifies ROE outcomes, increasing upside when operations perform well and worsening downside when they perform poorly.

When does leverage increase ROE?

When the return earned on assets/investments exceeds the cost of debt.

When does leverage hurt ROE?

When the return earned on assets/investments falls below the cost of debt.

★ EXAM: Why might shareholders favour high leverage?

It can increase ROE and avoids ownership dilution when business performance is strong.

★ EXAM: Why do bondholders dislike high leverage?

It increases financial distress and default risk and reduces the asset cushion protecting their fixed claim.

What is dilution?

A reduction in existing shareholders' fractional ownership caused by issuing new shares.

★ EXAM: Is ownership dilution certain when new shares are issued?

Yes. Existing shareholders' percentage ownership is diluted when new shares are issued.

★ EXAM: Is an EPS decline necessarily certain when new shares are issued?

No. The EPS effect depends on the earnings generated relative to the increase in shares outstanding.

Why might existing shareholders prefer debt financing to issuing equity?

Debt avoids ownership dilution and can increase ROE when the investment return exceeds the borrowing cost.

What is the downside of financing growth with debt?

Higher mandatory payments, leverage and financial distress risk.

What are shareholders generally motivated to maximise?

Firm/equity value and their residual return.

What are lenders generally motivated to maximise?

The probability of receiving timely interest and principal payments.

What actions tend to be preferred by shareholders but disliked by lenders?

Higher-risk projects, greater leverage, and potentially larger dividends or share repurchases that reduce the asset cushion supporting debt.

What actions do bondholders generally prefer?

Lower-risk projects, lower leverage, adequate asset coverage and contractual restrictions protecting repayment.

★ EXAM: Who usually benefits more from increased corporate risk-taking?

Shareholders, because they capture residual upside while bondholders' upside remains capped.

★ EXAM: Who is protected by debt covenants?

Bondholders/lenders.

What is a stakeholder?

Any individual or group with a vested interest in a company.

Who are the major corporate stakeholder groups?

Shareholders, debtholders, board of directors, managers, employees, customers, suppliers, governments, society and the environment.

What is shareholder theory?

The view that the firm's primary objective is to maximise shareholder value; other stakeholder interests matter insofar as they affect shareholder value.

What is stakeholder theory?

The view that corporate governance should consider the interests of all stakeholders, not only shareholders.

★ EXAM: What is the key distinction between shareholder and stakeholder theory?

Shareholder theory prioritises shareholder value; stakeholder theory explicitly considers all stakeholder interests.

Why can stakeholder theory be difficult to implement?

Multiple objectives may conflict and can be difficult to define, measure and balance; ESG standards can also impose costs and competitive constraints.

What do shareholders provide and want?

They provide permanent capital and generally seek maximised firm value, dividends and voting influence.

What do private debtholders provide and want?

They provide loans, credit facilities and leases and seek timely interest/principal payments and covenant compliance.

Who are private debtholders?

Banks and other institutions providing loans, credit facilities and leases.

Who are public debtholders?

Bondholders who provide financing through publicly issued bonds.

★ EXAM: Bondholders are classified as what type of debtholder?

Public debtholders.

What information advantage do private debtholders often have?

Direct management access and potentially non-public information, reducing information asymmetry.

What information do public bondholders primarily rely on?

Public information such as published financial statements and the contractual terms established at issuance.

★ EXAM: Who usually has greater direct influence over management: private or public debtholders?

Private debtholders, particularly when a lender is an important source of the firm's financing.

★ EXAM: Who is generally more willing to renegotiate debt terms: private lenders or public bondholders?

Private lenders.

Why can a dominant private lender have substantial bargaining power?

The issuer may depend heavily on that lender for financing, while the lender also has greater information and direct management access.

When can public bondholders gain significant influence?

During financial distress or restructuring of outstanding public debt.

What is the board of directors' basic role?

To oversee the corporation, monitor management, set strategic direction and hire or fire the CEO.

Who elects the board of directors?

Shareholders.

What is an inside director?

A founder or current/former manager with close ties to the company and significant firm-specific knowledge.

What is an independent director?

A director with no material relationship with the company, such as employment, family ties or material business links.

★ EXAM: Are inside directors independent?

No. Inside directors are not independent directors.

What is the trade-off with inside directors?

They possess greater company-specific knowledge but may have greater conflicts of interest with shareholders.

Why are independent directors valuable?

They provide more objective oversight and may better protect shareholder interests, particularly minority shareholders.

★ EXAM: What do major exchanges typically require regarding board independence?

A majority, or at least a substantial element, of the board should be independent.

What is a one-tier board?

A single board containing both inside and independent directors; common in the USA and UK.

What is a two-tier board?

A structure with a separate supervisory board overseeing the management/director board.

Where are two-tier boards common?

Continental Europe; they are legally required in some jurisdictions, including Germany.

Who may sit on a supervisory board in a two-tier system?

Representatives of shareholders, employees, labour unions, the public and sometimes government.

★ EXAM: Which board structure may explicitly include employee representatives?

A two-tier board through its supervisory board.

What is a staggered board?

A board whose directors are divided into groups elected in different years.

How does a staggered board affect shareholder control?

It makes it harder and slower for shareholders to replace the entire board.

★ EXAM: Which structure least permits a rapid change of corporate control?

A board with more insiders and more staggered elections.

★ EXAM: Which features give shareholders greater ability to replace a board?

More independent directors combined with simultaneous rather than staggered elections.

Why can staggered boards entrench incumbent management?

An acquirer or dissatisfied shareholders cannot replace the full board in a single election cycle.

What do managers provide to the company?

Strategy execution and day-to-day operational decision-making.

What do managers generally want?

Compensation, job security and career advancement.

How can management compensation align managers with shareholders?

Performance bonuses and long-term stock-based incentives give managers financial exposure to company performance.

What do employees provide to a company?

Human capital: their labour, skills, knowledge and expertise.

★ EXAM: What is human capital?

The labour, skills, knowledge and expertise supplied by employees.

What do employees generally want?

Competitive compensation, development opportunities, job security and a safe and healthy workplace.

How can employee equity participation align employees with shareholders?

Profit sharing, share purchase plans, stock options and similar arrangements give employees a financial stake in company performance.

What do customers provide and want?

Customers provide revenue and seek quality, safety, reasonable prices, service and ethical conduct.

What leverage do customers have over a company?

They can switch competitors, leave reviews, boycott products or otherwise reduce demand.

What do suppliers provide?

Raw materials, intermediate goods, software and outsourced services.

Why are suppliers often considered short-term creditors?

They may deliver goods or services before receiving payment, effectively extending trade credit to the company.

What do suppliers generally want?

Timely payment, continued business relationships and the customer's financial stability.

Why might a supplier oppose high financial leverage at a customer?

Higher leverage increases the customer's distress risk, threatening both payment of current receivables and the value of customer-specific investments.