Question

which of the following statements is correct? because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects. since bondholders receive fixed payments, they do not share in the gains if risky projects turn out to be highly successful. however, they do share in the losses if risky projects fail and drive the firm into bankruptcy. therefore, bondholders generally prefer to see corporate managers invest in low risk/low return projects rather than high risk/high return projects. one advantage of operating a business as a corporation is that stockholders can deduct their pro rata share of the taxes the firm pays, thereby eliminating the double taxation investors would face in a partnership. one drawback of forming a corporation is that you lose the limited liability that you would otherwise receive as a proprietor. potential conflicts between stockholders and bondholders are increased if a firms bonds are convertible into its common stock.

Explanation:

1. Bondholders prefer low - risk projects as they get fixed payments and bear losses in case of bankruptcy. High - risk projects may lead to bankruptcy and they may not get paid in full.
2. Stockholders in a corporation cannot deduct the firm's tax payments.
3. Forming a corporation provides limited liability, not the other way around.
4. Convertible bonds can reduce the conflict between stockholders and bondholders as bondholders may benefit from stock price appreciation.

Answer:

Since bondholders receive fixed payments, they do not share in the gains if risky projects turn out to be highly successful. However, they do share in the losses if risky projects fail and drive the firm into bankruptcy. Therefore, bondholders generally prefer to see corporate managers invest in low risk/low return projects rather than high risk/high return projects.