lecture 12: Agency Theory 2 Flashcards
what is debt overhang?
a situation in which equity holders choose not to invest in a positve NPV project because the value of undertaking the investment opportunity will go to debt holders rather than themselves
when does the debt overhang arise?
debt overhang arises when debt is risky ie there is a possibility that the firm faces financial distress
what NPV would equity holders require in order to invest?
it can be shown that shareholders will only invest if the NPV/I > B_d/B_e * D/E where NPV is net present value, I is the intial investment required, B_D is the firms debt beta and B_E is the firms equity beta, D and E are firms debt and equity
what is the interpretation of the firms NPV cut off point?
if D is equal to 0 then the firm is unlevered, shareholders will invest in all positive NPV projects.
if B_d =0 then debt is not risky and so shareholders will invest in all positive NPV projects. the debt overhang is more severe in highly leveraged firms (high D/E ratio) with risky debt (large B_d)
what is cashing out?
when a firm faces financial distress, shareholders have an incentive to withdraw money from the firm, if possible. for example, if it likely that the company will default,the firms may sell assets below market value and use the funds to pay an immediate cash dividend to the shareholders, this is another form of underivestment that occurs when a firm faces financial distress,
how can leverage encourage managers and shareholders to act in ways that reduce firm value?
it appears that the equity holders benefit at the expense of the debt holders. the shareholders benefit from the equity holders ability to exploit debt holders in times of distress. the debt holders recognise this possibility and pay less for the debt when it is first issued. ultimately its the shareholders of the firm who bear these agency costs. thus agency costs of a debt can arise only if there is a chance of the firm defaulting and imposing losses on debt holders
how does the magnitude of the agency cost react to changes in risk and the amount of the firms debt?
the magnitude of the agency costs increase with the risk and amount of the firms debt
how does the maturity of debt impact the magnitude of the agency costs?
agency costs are highest for long term debt and smallest for short term debt. remember the firm has to face the possibility of a financial distress for the firm to be exposed to these agency costs
what are debt covenants
they are conditions of making a loan in which the credititors place restrictions on actions that a firm can take ( e.g. restricting the firms ability to pay large dividends, take on further debt, or maintain a certain amount of working capital)
how do covenants limit the agency costs of debt?
covenants may help to reduce agency costs, because covenants hinder management flexibility. however, they have the potential to prevent investment in positive NPV opportunities and so can have costs of their own
