B6 Debt and Agency Problems

Question 1

Definition asset substitution problem (3)

Answer 1

… a problem that arises when a company exchanges its low-risk assets for high-risk investments.

This substitution transfers value from a firm’s debt holders to its shareholders.

Shareholders have an incentive to invest in negative-NPV projects that are risky and reduce overall firm value.

Question 2

Debt overhang: behavior of equity-holders

Answer 2

When a firm is highly leveraged and debt is risky, equity holders have a disincentive to raise new capital to invest in positive-NPV projects, when debt-holders receive most of the benefit.

Equity holders benefit from new investments only if:
NPV/I > ß_DD/ß_EE

Question 3

Fiduciary duties of management and its problem

Answer 3

US: management should take actions that are in the interest of the owners (max. shareholder value)

Problem: This does not necessarily lead to welfare maximization (externalities)

Question 4

Agency cost of debt: Debt maturity and covenants

Answer 4

Agency costs of debt vary in maturity of debt: They are highest for long-term debt and smallest for short-term debt.

Firms can mitigate agency costs through debt covenants:

• conditions of making a loan in which creditors place restrictions on actions that a firm can take
• covenants help to reduce agency costs but can have costs of their own as they hinder management flexibility, i.e. have the potential to prevent investments in positive-NPV projects

Question 5

Agency benefits of leverage: mitigating management entrenchement (adding discipline through leverage)

Answer 5

Problem Management Entrenchment:
A situation arising as the result of the separation of ownership and control where managers may make decisions that benefit their own but are not in the shareholders’ best interest.

Solution: Using leverage allows owners of the firm to maintain their equity stake.
Leverage may commit managers to pursue strategies with greater vigor than they would without the threat of financial distress

Question 6

3 agency problems between management and shareholders

Answer 6

1. Managers may engage in empire building: make investments that increase size but not necessarily profitability
2. Managers may over-invest due to overconfidence

3. **Free Cash Flow hypothesis: After making all +NPV investments and payments to debt holders,wasteful spendingismore likelyto occurwhen there are high levels of CF left**

Question 7

formula Agency costs and Trade-off theory

Answer 7

V^L = V^U + *PV *(interest tax shield) — *PV *(financial distress costs) — *PV *(Agency costs of debt) + *PV *(Agency benefits of debt)

Question 8

Summary Debt and Agency Problems (3)

Answer 8

(1) asset substitution problem: when a firm faces financial distress, shareholders can gain from investment decisions that increase the risk of the firm sufficiently, even if investments have negative NPV

(2) debt overhang: when a firm faces financial distress, it may choose not to finance new, positive-NPV projects

(3) Agency benefits of debt: added discipline