Q3 - Agency costs Flashcards
What is the agency problem due to
- conflicts of interest between agent and
principal - asymmetric information: the agent has private information about her actions and/or other payoff relevant parameters
Agency costs are due to
agent’s departure from value-maximising decisions = residual loss
monitoring expenses - costs incurred by principal in trying to control and remedy the agent’s actions
bonding (alignment) costs - costs incurred by agents in trying to align with principal’s interests
2 Agency costs of equity
conflicts between shareholders (i.e., principal) and managers (i.e., agent)
conflicts between large shareholders (i.e., agent) and minority shareholders (i.e., principal)
Agency costs of debt
conflicts between shareholders (i.e., agent) and a specific stakeholder, bondholders (i.e., principal)
Describe the Bondholder Wealth Expropriation Hypothesis
conflicts of interest and asymmetric information between shareholders and relatively uninformed bondholders gives rise to an agency conflict.
Shareholders (or managers acting in their interest) want to maximise equity value rather than total firm value even if this involves reducing debt value
Debtholders own an asset worth the present value of the redemption value of debt. which will only be paid back if the firm value is greater than the value of debt
Sources of debtholder-shareholder conflicts:
Detail the Asset substitution / risk shifting problem
Managers increase volatility either by shifting from safer to riskier assets or by adopting risky investment projects, even with negative NPV
Shareholders benefit from more upside risk, while debtholders bear increased downside risk
Sources of debtholder-shareholder conflicts:
what are the 2 consequences of the Debt overhang problem
Underinvestment (Myers, 1977)
Shortsighted investment problem
Debt overhang problem:
Detail the underinvestment problem
In firms with existing senior debt obligations, if there is a new investment, shareholders will refuse to contribute
additional funds to undertake this investment. As part of the shareholders’ benefits from the new project
will accrue to the outstanding debtholders, making their investment not profitable on their part
Managers then act in shareholder interest
Debt overhang problem:
Detail the shortsighted investment problem
Highly leveraged firms are likely to pay higher rates of interest on new subordinated debt raised to refinance the portion of outstanding debt until the maturity.
They will prefer projects with lower NPV that pay off quickly than higher NPV projects with lower initial cash inflow
Sources of debtholder-shareholder conflicts:
Reluctant liquidation
The conflicts of interest between shareholders and debtholders are intensified when the firm is close to
or in financial distress
liquidation costs = going concern value - liquidity value
Firms will prefer not to liquidate even if the
liquidity value is higher than the going concern value, because shareholders are likely to receive nothing from a liquidation and managers to lose their jobs
Sources of debtholder-shareholder conflicts:
Increasing dividends
This would reduce firm’s asset value by financing the increase dividends with reduction in investment. At the
limit, if the firm sells all its assets and pays a liquidating dividend to the shareholders, the debtholders are left with worthless claims
Sources of debtholder-shareholder conflicts:
Increasing leverage
If firms issue additional debt of the same or higher priority of the outstanding debt all the total debt is riskier and old debtholders’ claim is reduced.
What is credit rationing
Since debtholders rationally anticipate potential debt agency problems, they will require a higher return on debt to compensate them for the loss in debt value
The firm may be able to reduce the agency cost of debt by establishing control mechanisms.
Name the 4 most common control mechanisms
Debt covenants
Maturity
Private vs Public debt
Convertible debt
What are debt covenants
These are contractual clauses that place specific operating and financial constraints on the borrower. They allow the
lender to monitor and control borrower’s activities
Positive covenants. They specify things borrowers “must do”.
Examples of positive debt covenants
They have to: maintain and supply satisfactory accounting records/audited financial statements
Pay taxes
Maintain a certain level of liquidity in the company
Maintain life insurance for certain “key employees”
Negative covenants. They specify things borrowers “must not do”
Examples of negative debt covenants
Borrowers may not sell receivables, maintain certain fixed assets
Borrowers may be prohibited to borrow additional long-term debt or they may issue new subordinated debt.
Borrowers may be prohibited to increase the salary payments for certain employees.
A common provision prohibits the annual cash dividends to exceed 50-70% of firm’s earnings or a specified amount.
How does the maturity of debt impact the debt overhang conflicts
conflicts are exacerbated when firms have more long-term debt than short-term debt
Having more short-term debt may alleviate
these conflicts. In fact, with short-term debt, the interest payment on all firm’s debt will be renegotiated.
However short term debt increases liquidity risk and lowers the tax advantage for the firm
Advantages of bank debt over public debt
Banks better monitor firms’ activities and collect and process information
They can enforce more stringent covenants
because the renegotiation process is easier when firms need financing
Disadvantages of bank debt instead of public debt
banks may prefer to continue to lend even in suboptimal cases, because of
signalling/reputational incentives and/or
related lending
firms may be “informationally” captured by
banks because banks have bargaining power over the firm’s profits. If firms cannot choose other borrowing sources, bank debt may be very costly
List all of the potential agency costs of debt
Risk shifting / asset substitution
Debt overhang = Underinvestment + Short-sighted investment problems
Reluctant liquidation
Excessive dividend payments
increasing leverage
