On the Magnitude of Stockholder-Bondholder Conflicts

38 Pages Posted: 13 Jan 1997

See all articles by Robert Parrino

Robert Parrino

University of Texas at Austin - Department of Finance

Michael S. Weisbach

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Date Written: January 1997

Abstract

This paper numerically estimates the magnitude of the stockholder/bondholder conflict. Given a standard valuation model with parameters picked from the data, we compute the expected change in firm value and decompose this change into stockholder and bondholder components. We then characterize the set of positive net present value projects that stockholders would prefer to ignore (the "underinvestment problem") and the set of negative net present value projects that stockholders would like to accept (the "overinvestment problem").

The results quantify the distortions from both underinvestment and overinvestment and verify that both increase with the quantity of debt in the capital structure. For example, if the risk-free rate is 7.16%, stockholders of an all-equity firm will accept only risk-free projects with a return higher than this rate. When the firm has a 20% debt to total capital ratio, the minimum acceptable return is 7.53%, and when the debt to total capital ratio is 40%, the hurdle rate increases to 8.01%. However, this effect is far too small to offset the value of the tax shields associated with debt, and thus is unable to explain the vast majority of variation in capital structure.

JEL Classification: G10

Suggested Citation

Parrino, Robert and Weisbach, Michael S., On the Magnitude of Stockholder-Bondholder Conflicts (January 1997). Available at SSRN: https://ssrn.com/abstract=1639 or http://dx.doi.org/10.2139/ssrn.1639

Robert Parrino

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-471-5788 (Phone)
512-471-5073 (Fax)

Michael S. Weisbach (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

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