Question 49 from UPSC CSE 2025 - Economics

Question

Consider the following statements:
1. As regards returns from an investment in a company, generally, bondholders are considered to be relatively at lower risk than stockholders.
2. Bondholders are lenders to a company whereas stockholders are its owners.
3. For repayment purpose, bondholders are prioritized over stockholders by a company.
Which one of the following is correct in respect of the above statements?

Accepted Answer

Correct Option: A. Both Statement II and Statement III are correct and both of them explain Statement I

Strategy: Directly link the rationale behind risk difference in investment types. Statement I establishes the risk hierarchy between bondholders and stockholders. Statement II clarifies the fundamental role distinction—bondholders as lenders, stockholders as owners—while Statement III addresses the priority of repayment. Both Statement II and III provide the reason why bondholders face lower risk than stockholders, thus both statements explain Statement I. Validate that neither of II nor III is incorrect, verifying their explanatory value for Statement I, leading directly to option A.

Key Info: Bondholders and stockholders are two primary categories of investors in a company:

- Bondholders invest via debt instruments (bonds or debentures). They are creditors to the company and receive fixed payments (interest/coupon). In case of liquidation, bondholders are paid from company assets before stockholders, making their investment comparatively less risky.
- Stockholders, also called shareholders, own equity in a company and have residual claims on assets after creditors are paid. Returns to stockholders come in the form of dividends (if declared) and capital appreciation, both of which are not guaranteed.
- Repayment preference: Under bankruptcy or liquidation, the claims of creditors (including bondholders) are settled first. Only after all debts are repaid, remaining assets (if any) are distributed among stockholders.
- The lower risk for bondholders is justified by their status as creditors with legal claims and repayment seniority. Stockholders, as owners, benefit from company profits but bear more risk.
- The distinction between debt (bonds) and equity (stocks) is fundamental in corporate finance; this underpins financial market structure and regulation (e.g., Companies Act, SEBI guidelines).

Answer

Option B: Both Statement I and Statement II are correct and Statement II explains Statement I

Answer

Option C: Only one of the Statements II and III is correct and that explains Statement I

Answer

Option D: Neither Statement II nor Statement III is correct