Consider the following statements Statement I: As regards returns from an investment in a company, generally, bondholders are con…

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 prioritized over stockholders by a company.

Which one of the following is correct in respect of the above statements?

1. A. Both Statement II and Statement III are correct and both of them explain Statement I (Correct answer)
2. B. Both Statement I and Statement II are correct and Statement I explains Statement II
3. C. Only one of the Statements II and III is correct and that explains Statement I
4. D. Neither Statement II nor Statement III is correct

Correct Answer

Option A — Both Statement II and Statement III are correct and both of them explain Statement I

Detailed Solution & Explanation

The correct answer is Both Statement II and Statement III are correct and both of them explain Statement I.

Key Points

• both Statement II and Statement III are correct, and both explain Statement I.
• Explanation: Statement I is correct: bondholders generally carry lower risk than stockholders.
• Statement II explains why — bondholders are lenders (creditors) entitled to fixed interest regardless of whether the company profits, whereas stockholders are owners whose returns depend entirely on performance.
• Statement III independently explains it too — on repayment or liquidation, bondholders rank ahead of stockholders in the claim hierarchy, so they are far likelier to recover their money.
• Since both II and III are correct and each explains the lower risk in Statement I, Option A is right.

Additional Information

• The order of claims on a company's assets runs: secured creditors, then unsecured creditors and bondholders, then preference shareholders, and finally equity shareholders.
• That residual position is exactly why equity carries the highest risk and the highest potential return.