Tutorial 3: How might agency costs of free cash flows be a serious problem for firms? Flashcards
What are free cash flows (FCFS)?
Cash flow in excess of that required to fund all +ve NPV projects –> can be used to pay dividends to shareholders or repurchase shares.
Why do agency costs of FCFs pose serious problems for firms?
LEADS TO AGENCY PROBLEMS I.E. CONFLICTS OF INTEREST BETWEEN SHAREHOLDERS & MANAGERS –> managers may be incentivised to exploit private benefits using FCF rather than max. value of firm & shareholder return, e.g. via:
1) Empire building –> using FCF to grow firm beyond its optimal size –> increase manager power & compensation (+vely related to firm’s sales growth) –> such unnecessary growth may be wasteful investment that does not max. shareholder wealth.
2) Avoid external capital financing –> i.e. using FCFs to finance projects internally avoids the need to seek external capital financing from outside investors, which may come w external monitoring/scrutiny –> managers can maintain control over decision-making & carry out these privately beneficial actions w/out facing accountability to shareholders & external stakeholders.
What are the benefits & drawbacks in using debt policies to reduce agency costs of FCFs for firms?
BENEFITS:
1) SHARE REPURCHASE: Firms can use debt issuance proceeds to conduct share repurchases –> reduces FCFs misuse by managers for personal gain or inefficient investments –> helps align shareholder-manager interests.
2) Threat of bankruptcy: Managers may be disincentivised from carrying out wasteful investments & may operate more efficiently as firms risk bankruptcy if unable to meet debt obligations –> helps align shareholder-manager interests.
3) Tax advantages: Interest payments on debt are tax-deductible –> tax shield increases overall value of firm & may lower cost of capital –> helps align shareholder-manager interests.
DRAWBACKS:
1) Financial distress costs: high debt levels pose risk of bankruptcy if firm cannot honour its debt obligations –> can harm firm’s ability to expand and invest in value-enhancing projects to max. shareholder returns –> reduces shareholder return.
2) May worsen debt holder-shareholder conflicts –> debtholders have higher priority in firm’s capital structure before shareholders in event of liquidation –> reduces shareholder return.
What are the benefits & drawbacks in using dividend policies to reduce agency costs of FCFs for firms?
BENEFITS:
1) REDUCE FCF USE BY MANAGERS: if dividends paid out to shareholders there is less scope for mangers to wastefully and inefficiently use FCFs in investment projects –> helps align manager-shareholder interests.
DRAWBACKS:
1) SIGNALS LACK OF INVESTMENT OPPORTUNITIES: firm’s valuation may be -vely impacted by high dividend payments as investors may perceive that firm lacks profitable investment opportunities for future growth –> reduces shareholder returns.
2) NO CONTRACTUAL OBLIGATION –> firms not contractually obliged to pay dividends to shareholders (unlike paying interest to debtholders) –> further dividend reductions may lead to -ve market reactions due to uncertainty & volatility e.g. decreases in share price –> reduces shareholder returns.
How should firms determine their capital structure in the presence of manager-shareholder agency costs?
Lintner Model –> focuses on how firms set dividend policies over time –> emphasises importance of balancing need for current dividend payments w firm’s investment opportunities & future growth prospects –> e.g. issuing stable or gradually increasing dividend payments over time can signal financial stability to shareholders & reduce uncertainty –> firms can strategically allocate cash flows towards value-enhancing projects while also providing consistent returns to shareholders to mitigate inefficient use of free cash flow, as managers incentivised to make prudent investment decisions that align with long-term shareholder value creation –> firms need to carefully consider capital structure decisions (use of debt & dividend policies) to mitigate agency costs of FCF to align managerial incentives w shareholder interests.
Which events are examples of FCF misuse?
EARLY 1970s OIL INDUSTRY TAKEOVERS –> large CFs due to price increases –> need for shrinking due to excess capacity & large agency cost of FCF issues –> in response managers implemented diversification programs aiming to utilise excess cash but were usually unprofitable (could have been due to bad luck/lack of expertise) –> diverted FCFs away from shareholders of acquiring firms to shareholders of target firms –> generated returns outside of acquiring firm–> highlights agency costs associated w FCF mismanagement.
What is the FCF theory of takeovers?
TAKEOVERS CAN BE A SYMPTOM OR SOLUTION OF FCF MISMANAGEMENT & AGENCY COSTS:
1) Symptom: Firms w large FCFs can become takeover targets –> when excess cash not effectively invested in value-enhancing projects or returned to shareholders, it can signal capital allocation inefficiencies & potential manager-shareholder agency conflicts –> can attract acquirers looking to reallocate resources more efficiently & improve overall econ. performance of target firm.
2) Symptom: Firms may use FCFs in low-value or value-destroying mergers/takeovers e.g. diversification programs instead of paying out dividends to its shareholders –> decreases shareholder returns –> may worsen manager-shareholder agency costs.
2) Solution: Firms can reduce FCFs in takeovers e.g. diversification programs –> potential benefit of such transactions in that they may involve less value reduction than if FCFs had been internally invested in
unprofitable projects –> funds may be more productively utilised in target firm if it has better investment opportunities or operational expertise compared to its wasteful use in acquiring firm’s projects which may generate insufficient returns –> may reduce manager-shareholder agency costs by providing more value to shareholders.
–> Takeovers financed w combo of cash & debt likely to generate larger benefits compared to those financed through exchange of stock –> financial distress risk of debt incentivises cuts in wasteful investment projects & cash provides immediate liquidity for transaction –>
debt financing also offers tax advantages & lower cost of capital compared to equity financing, allowing acquiring firm to max. the value of transaction –> cash reserves can also be retained for future investment/operational needs.
