1. Asset or investment substitution - The shareholders, acting through management, have an incentive to induce the firm to take on new projects that have a greater risk than was anticipated by the firm's creditors. The increased risk will raise the required rate of return on the firm's debt, which in turn will cause the value of the outstanding bonds to fall. If the risky capital investment project is successful, all of the benefits will go to the firm's stockholders, because the bondholders' returns are fixed at the original low-risk rate. If the project fails, however, the bondholders are forced to share in the losses.
2. Borrowing more debt capital - Managers can also increase the firm's level of debt, without altering its assets, in an effort to leverage up stockholders' return on equity. If the old debt is not senior to the newly issued debt, its value will decrease, because a larger number of creditors will have claims against the firm's cash flows and assets. Both the riskier assets and the increased leverage transactions have the effect of transferring wealth from the firm's bondholders to the stockholders.
3. Disposal of assets used as collateral – disposal of securities used to acquire loans exposes the creditors to more risk as they may not recover the money advanced to the business in case of liquidation.
4. Payment of high dividend – the payment of high dividends leads to low capital and investment and this reduces the market value of bonds, shares and debentures.
5. Under investment – this is scenario where the company fails to invest the whole amount of money advanced by the creditors. This results in the reduction value of the business and subsequently the value of bonds and debentures.
Lellah answered the question on November 8, 2021 at 06:33