Contrast what lenders and shareholders are entitled to and what drives each group
The idea
Lenders and shareholders hold very different claims on the same business. Lenders are owed contractual interest and principal, rank ahead of shareholders in liquidation and gain nothing beyond the promised payments, so their focus is the downside: will the firm be able to pay? Shareholders hold the residual claim, keeping everything left after creditors are paid, with unlimited upside and, thanks to limited liability, a loss capped at their investment. Equity therefore behaves like a call option on the firm's assets with a strike equal to the debt. That asymmetry creates conflict: shareholders of a leveraged firm may favour riskier projects that shift value from lenders to themselves, which is why lenders protect themselves with covenants, collateral and higher required returns.
A practice question
Compared with shareholders, lenders to a company have a claim that is:
- fixed and senior — correct
- residual and juniorWhy not: A residual, junior claim describes shareholders, who are paid only after all creditors.
- fixed but juniorWhy not: Lenders' fixed claims rank ahead of equity, so they are senior, not junior.
Lenders are owed contractual interest and principal and are paid before shareholders. Shareholders hold the residual claim on whatever remains after all obligations are met.
A harder one
A company is liquidated with assets of 80 against debt with a face value of 100. The amounts received by lenders and shareholders are:
- lenders 100, shareholders 0Why not: Lenders cannot receive more than the company has; with assets of 80, their claim of 100 is not fully met.
- lenders 80, shareholders 0 — correct
- lenders 80, shareholders 20Why not: Shareholders receive nothing until lenders are paid in full; there is no residual left for equity.
Lenders' claims rank ahead of equity, so the full 80 goes to lenders, who suffer a loss of 20. Shareholders' residual claim is worth zero, and limited liability means they owe nothing further.
The hardest tier
A firm owes 100 of debt due in one year. It can choose a safe project worth 100 for certain, or a risky one worth 150 or 50 with equal probability. The expected payoff to shareholders from each is:
- safe 0, risky 50Why not: This treats the good-state payoff of 50 as certain, ignoring the equal chance that equity receives nothing.
- safe 0, risky 0Why not: In the good state equity receives 150 - 100 = 50, so the risky project has positive expected value to shareholders.
- safe 0, risky 25 — correct
Safe: assets of 100 exactly repay debt, leaving equity 0. Risky: equity gets 50 or 0, an expected 25, while debt expects 0.5 x 100 + 0.5 x 50 = 75. Both projects have the same expected value of 100, yet risk shifts 25 from lenders to shareholders.
In the app: 6 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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