What does risk tolerance mean in this relationship??
is it related to perception of taking risks involving any business decision?
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Risk tolerance here means that sometimes the management can take excessive risk in the company which might hurt the shareholders as excessive risk can put the company in unfavorable situations and the shareholders may lose their entire wealth as a result of some unwanted event . Typically it can be found when management has a Stock option or a call option with them. Management thinks if the project goes in their favour, the returns are going to be beyond amazing and if it doesn’t work out in their favour, the call option will lapse and they will not exercise it.
See there’s a conflict between shareholders and managers regarding risk tolerance on the basis that shareholders wants company to take specific risk as all risks are not avoidable company has to take certain risky project which might look risky but can be a great asset for the company . So when company’s undertake risky projects it might pay off and it will create companys value and hence cteate shareholders welath
But on the contrary management doesnt want company to take risk because if company invest in risky project from borrowed funds theres a chance that the project might not pay off well and theres a risk that company might go bankrupt if it continues to take risk and the management can loose their jobs . Since interest are paid on debt there will be no free cash flows left for the management .
Its like a status co bias in behavioural finanace
This is risk tolerance relation in this respect
Hope it helps
Thanks a lot Mohit.
Your welcome