CONSEQUENCES FOR DECISION MAKING

Option pricing theory can be applied to illustrate the conflict between stockholders and bondholders when it comes to investment analysis and conglomerate mergers. This section argues that decisions that make stockholders better off are not necessarily value maximizing for the firm and can hurt bondholders.

The Conflict between Bondholders and Stockholders

Stockholders and bondholders have different objective functions, and this can lead to agency problems, whereby stockholders expropriate wealth from bondholders. The conflict can manifest itself in a number of ways. For instance, stockholders have an incentive to invest in riskier projects than bondholders, and to pay more out in dividends than bondholders would like them to. The conflict between bondholders and stockholders can be illustrated dramatically using the option pricing methodology developed in the previous section.