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How managers raise the funds needed to operate the company

• Shareholder/Bondholder Conflicts of Interest

Changing the investment strategy from low-risk to high-risk investments
Gambling on high-risk negative NPV projects to escape bankruptcy
Selling assets and distributing cash without paying down debt
Selling new debt that has the same priority as existing debt

• The Events

The first event goes by the name of risk shifting.
The second item on the list is most likely to happen in companies that are facing financial problems. The managers decide to invest in MegaLottery because if they invest in MegaLottery and the investment fails or if they don’t invest, they will be out of a job and the shareholders will lose their investment in the company.
The third item is also known as ‘‘taking the money and running.’’ Rather than build up cash to make future interest and principal payments, the owner/managers distribute the cash as dividends. The result is cash leaving the company and a deterioration in the creditors’ position.
The fourth item describes situations in which owner/managers borrow, say, $100 million from one group of creditors and informally promise not to borrow any more money. However, the owner/managers then violate that promise and borrow another $50 million from another lender, giving the second lender the same priority in cash flows as the first group of creditors.

• How Creditors Protect Themselves with Covenants

Creditors protect themselves against these potential events by including covenants in debt contracts that prevent owner/managers from doing certain things and/or require them to do other things. The first are called negative covenants; the second, positive covenants.

• Shareholder/Manager Conflicts of Interest

One way to remove managerial control over free cash flow is to use debt financing.
Other ways to remove cash are to pay cash dividends or repurchase common stock.

• The Financing Decision and Customers

Our point is that customers are very interested in a company’s financial position and whether the company can deliver on its implied contracts with the customers if they pay for a product or service prior to receiving it.

• The Financing Decision and Employees

People are attracted to firms that offer employment security and prospects for personal development and growth.

• Bank debt versus public debt

Corporations can usually sell bonds at lower interest rates than they would have to pay for bank debt.

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