Which one of these best describes the relationship between bondholders and stock

Question

Which one of these best describes the relationship between bondholders and stockholders at a time when it appears the firm may be facing increased financial distress?

Stockholders have an incentive to underinvest in new projects to the detriment of bondholders.

Both parties tend to work together for the common good of the firm.

Both bondholders and stockholders will encourage the firm to take on new high risk projects.

Bondholders will tend to lower their required rate of interest so the firm can afford additional financing until its financial status improves.

Bondholders tend to milk the property at the expense of stockholders.

Explanation / Answer

The situation in which the firm may be facing financial distress, the bondholders will decrease the required rate of interest.

As a result of decrease in the interest rate the cost of the borrowing will decrease and the firm can borrow more at lower cost.

The firm can afford additional financing till the time the financial situation improves.

Hence, the correct option is D that is Bondholders will tend to lower their required rate of interest so the firm can afford additional financing until its financial status improves.

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