Agency problems

Question 1

What is the principal contract design?

Answer 1

How to design a contract to align the goals of the manager with the owner

Question 2

Why would a principal hire an agent?

Answer 2

If the principal is too busy to do a given job

Question 3

What is the goal of managers?

Answer 3

To maximise stockholder wealth

Question 4

What is the conflict of interest between shareholders and managers of the firm called?

Answer 4

The agency cost of equity

Question 5

What is the agency cost of equity caused by?

Answer 5

• Separation of ownership from control (hidden actions)
• Asymmetric information

Question 6

Why does the separation of ownership from control cause a problem?

Answer 6

Managers are in a position to maximise their own wealth without necessarily being “detected” by the owners of the company as they cannot be observed

Question 7

Why does assymetric information cause the agency cost of equity?

Answer 7

Managers have access to accounting data and financial reports whereas shareholders only receive annual reports which may be manipulated

Question 8

How can the agency costs of equity be mitigated?

Answer 8

• Corporate governance
• Direct managerial financial incentives

Question 9

What is corporate governance?

Answer 9

The system of rules, practises and processes by which a company is directed and controlled

Question 10

What are some different corporate governance approaches?

Answer 10

• Rules based
• Principals based

Question 11

What are direct managerial financial incentives?

Answer 11

• Incentives can be used to align management and stockholder interests
• Stock options for example
• Tying management compensation to measures such as EPS growth

Question 12

What is the agency cost of debt?

Answer 12

The conflict of interest between shareholders and debt holders

Question 13

When does a conflict of interest between shareholders and debt holders arise?

Answer 13

If investment decision have different consequences for the value of equity and the value of debt

Question 14

What do shareholders care about vs what do debt holders care about?

Answer 14

Shareholders care about equity, debt holders care about bond prices

Question 15

When is the agency cost of debt likely to occur?

Answer 15

Conflicts of interests between shareholders and debt holders arises if investment decision have different consequences for the value of equity and the value of debt. They are most likely to occur when there is a greater likelihood of financial distress

Question 16

When a firm is in financial distress, how can shareholders benefit?

Answer 16

Shareholders can gain at the expense of debt holders by taking a negative NPV project (excessive risk taking)

Question 17

What can debt-holders do to reduce their risk exposure from excessive risk taking with their money by equity holders?

Answer 17

Pay less for the debt initially and implement protective covenants restricting future actions

Question 18

What is debt-overhang and what does it lead to?

Answer 18

A situation in which equity holders choose not to invest in a positive NPV project because the value of undertaking the investment opportunity will accrue to bondholders rather than themselves.

Question 19

What does debt-overhang lead to?

Answer 19

Under-investment as shareholders choose not to invest because profits from the investment will go to the bond holders instead of them

Question 20

What you need to explain for full marks if asked to: Briefly explain the agency cost of debt and why the agency cost of debt could happen?

Answer 20

Explain that this occurs where there is a conflict of interest between the shareholders and the bond holders because of the differences in the value of equity and the value of bond holders. Point out that in the first case if managers take excessive risk, the equity holders might be able to gamble with the debt holders money, this is the point of conflict and may lead to over-investment into the very risky projects.

The second situation that could happen is debt-overhang where shareholders have no incentive to invest into new projects as the profit from new projects will go into the pockets of the debt holders instead of themselves resulting in under-investment.

Question 21

What is cashing out?

Answer 21

When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm if possible

Question 22

Is it harder to get rid of corporate bonds or stocks and shares?

Answer 22

Corporate bonds

Question 23

What are rewards?

Answer 23

Outcomes that people care about (both financial and non-financial rewards)

Question 24

What is effort?

Answer 24

Actions that people won’t take without rewards (not just hours worked)

Question 25

What are incentives?

Answer 25

Link between rewards and efforts (not just a compensation contract) eg. compensation that is sensitive to performance

Question 26

What is another type of under-investment that occurs when a firm faces financial distress?

Answer 26

Cashing out, when a firm faces financial distress. If default is likely, assets may be sold below their market value

Question 27

What does the role of the principal consist of?

Answer 27

Supply capital, bear risk and design an incentive scheme (a contract) for the agent.

Question 28

What can the principal be conceptualised as?

Answer 28

A representative shareholder or the board of directors

Question 29

What is the role of the agent?

Answer 29

The role of the agent is to exert effort in order to make sound managerial decisions on behalf of the principal