More Cap Structure

Question 1

What is the agency problem due to

Answer 1

• conflicts of interest between agent and
  principal
• asymmetric information: the agent has private information about her actions and/or other payoff relevant parameters

Question 1

Agency costs are due to

Answer 1

agent’s departure from value-maximising decisions = residual loss
costs incurred by principal in trying to control and remedy the agent’s actions
= monitoring expenses
costs incurred by agents in trying to align with principal’s interests = bonding (alignment) costs

Question 2

2 Agency costs of equity

Answer 2

conflicts between shareholders (i.e., principal) and managers (i.e., agent)
conflicts between large shareholders (i.e., agent) and minority shareholders (i.e., principal)

Question 3

Agency costs of debt

Answer 3

conflicts between shareholders (i.e., agent) and a specific stakeholder, bondholders (i.e., principal)

Question 4

Describe the Bondholder Wealth Expropriation Hypothesis

Answer 4

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

Question 5

Sources of debtholder-shareholder conflicts:
Detail the Asset substitution problem

Answer 5

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

Question 6

Sources of debtholder-shareholder conflicts:
what are the 2 consequences of the Debt overhang problem

Answer 6

Underinvestment (Myers, 1977)
Shortsighted investment problem

Question 7

Debt overhang problem:
Detail the underinvestment problem

Answer 7

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

Question 8

Debt overhang problem:
Detail the shortsighted investment problem

Answer 8

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

Question 9

Sources of debtholder-shareholder conflicts:
Reluctant liquidation

Answer 9

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

Question 10

Sources of debtholder-shareholder conflicts:
Increasing dividends

Answer 10

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

Question 11

Sources of debtholder-shareholder conflicts:
Increasing leverage

Answer 11

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.

Question 12

What is credit rationing

Answer 12

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

Question 13

The firm may be able to reduce the agency cost of debt by establishing control mechanisms.
Name the 4 most common control mechanisms

Answer 13

Debt covenants
Maturity
Private vs Public debt
Convertible debt

Question 14

What are debt covenants

Answer 14

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

Question 15

Positive covenants. They specify things borrowers “must do”.
Examples of positive debt covenants

Answer 15

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”

Question 16

Negative covenants. They specify things borrowers “must not do”
Examples of negative debt covenants

Answer 16

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.

Question 17

How does the maturity of debt impact the debt overhang conflicts

Answer 17

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

Question 18

Advantages of bank debt over public debt

Answer 18

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

Question 19

Disadvantages of bank debt instead of public debt

Answer 19

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