Previous Year Question
Consider the following statements:
Statement I: As regards returns from an investment in a company, generally, bondholders are considered to be relatively at lower risk than stockholders.
Statement II: Bondholders are lenders to a company whereas stockholders are its owners.
Statement III: For repayment purpose, bondholders are prioritised over stockholders by a company.
Which one of the following is correct in respect of the above statements?
Both Statement II and Statement III are correct and both of them explain Statement I.
Both Statement I and Statement II are correct and Statement I explains Statement II.
Only one of Statements II and III is correct and that explains Statement I.
Neither Statement II nor Statement III is correct.
Correct Answer: A
Detailed Solution
Statement I is correct. Bondholders are generally considered to face relatively lower risk than stockholders. Interest payments and repayment of principal on bonds are contractual obligations, whereas returns to stockholders depend on the company’s profits and the market value of its shares.
“Lower risk” does not mean risk-free. A bondholder may suffer losses because of company default, changes in interest rates or a decline in the market value of the bond.
Statement II is correct and explains Statement I. An investor purchasing a bond lends money to the company. A bondholder is therefore a creditor, not an owner of the company. The bondholder is ordinarily entitled to interest at the specified rate and repayment of principal at maturity.
A stockholder, in contrast, holds a part of the company’s equity capital and is one of its owners. Dividend payment is not contractually guaranteed. A company may decide not to distribute a dividend and may reinvest its profits.
Statement III is also correct and explains Statement I. In the event of liquidation or insolvency, creditors’ claims are paid before the claims of equity shareholders. Shareholders are called residual claimants because they receive a payment only if funds remain after claims having higher priority have been satisfied.
A simplified priority order is:
Creditors’ claims ⟶ Preference shareholders ⟶ Equity shareholders
In an actual insolvency process, the priority of secured creditors, insolvency costs, employees and government dues is governed by the applicable law. Nevertheless, the general principle remains that debt claims receive priority over equity claims.