© prentice hall, 2004 14 corporate financial management 3e emery finnerty stowe agency theory
TRANSCRIPT
© Prentice Hall, 2004
1414
Corporate Financial Management 3e
Emery Finnerty Stowe
Agency Theory
Principal-Agent Relationships
An agent has decision-making authority that affects the well-being of the principal.Examples of agents: Money managers Lawyers Corporate managers
Examples of principals: Investors in a money market fund Clients of lawyers Stockholders of the firm
Agency Problem
An agency problem arises when there is a conflict of interest between the agents and the principals.
It can also arise due to asymmetric information: The principal cannot monitor the agent’s behavior
perfectly.
Moral hazard can occur when agents take actions in their own best interest that are unobservable by and detrimental to the principal.
The Role of Monitoring
The principal can monitor the agent’s actions, but not perfectly.Costs are incurred in monitoring the agent’s behavior.Perfect monitoring of all actions of the agent can eliminate the agency problem. This can be prohibitively costly.
There is a trade-off between resources spent on monitoring and the possibility of agent misbehavior.
Alternatives to Monitoring
Alternatives to monitoring include: Constraints on agent’s behavior. Incentives to align agent’s interests with the
principal’s interests. Punishments for agent misbehavior.
Principal-agent contracts that eliminate all agency problems cannot be designed. Thus, a residual agency problems remains.
Agency Costs
These are costs incurred in an attempt to push agents to act in the principal’s best interest.
They are the incremental costs of working through others.
They consist of three types: Direct contracting costs Monitoring costs Loss of principal’s wealth due to residual, unresolved
agency problems.
Direct Contracting Costs
Transaction cost of setting up a contract. e.g. Legal fees
Opportunity costs imposed by constraints that preclude otherwise optimal decisions. e.g. Inability to take positive NPV projects due to
restrictive bond covenants.
Incentive fees paid to agents to encourage behavior consistent with the principal’s goals. e.g. Employee bonuses.
Role of Financial Contracting
To design financial contracts between agents and principals that minimize total agency costs.
Perfect contracts that eliminate all agency problems are not feasible. Periodic misbehavior may be less costly than the cost
of eliminating it.
The optimal contract transfers decision-making authority from the principal to the agent in the most efficient manner.
Stockholder-Manager Conflicts
Created by the separation of ownership and control of the corporation.
Stockholders elect the Board of Directors, who in turn appoint managers.
The self-interested behavior of managers may be at conflict with the interest of stockholders.
Stockholder-Manager Conflicts
Managers may favor growth and larger size of the firm: Greater job security Larger compensation Greater prestige Larger discretionary expense accounts
Stockholder-Manager Conflicts
Consumption of excessive perquisites. Direct benefits: use of company car, expense accounts. Indirect benefits: up-to-date office decor.
Shirking They may not put forth their best efforts.
Non-Diversifiability of Human Capital Managers’ expertise is closely tied to the firm. This leads to a divergence of goals.
Non-Diversifiability of Human Capital
Capital Investment Choices Preference for low-risk projects even though their NPV
may be lower than other riskier projects. If the firm ceases to operate as a result of “bad”
outcomes of risky projects, managers lose their jobs.
Asset Uniqueness The more a manager’s human capital is closely tied to
the firm, the more unique the assets of the firm are.
Debtholder-Stockholder Conflicts
When a firm issues risky debt, stockholders have an option against the debtholders. The option to default on debt.
Now, stockholders are the agents and the debtholders are the principals. Debtholders want to protect themselves against
adverse decisions taken by stockholders.
Debtholder-Stockholder Conflicts
This conflict can manifest in three ways: Asset substitution Underinvestment Claim Dilution
Asset Substitution Problem
Occurs when riskier assets are substituted for the firm’s existing assets. This appropriates wealth from the firm’s existing
debtholders.
Stockholders have the option to default on debt.
As the risk of the firm’s investments increases, the value of this option increases. the expected payment to debtholders decreases.
Asset Substitution Problem
Total Firm Value
Promised Payment to
Debtholders
Market
Value
of Debt
Market
Value of
Stock
Before Risky InvestmentsTotal Firm Value
Promised Payment to Debtholders
Market
Value
of Debt
Market
Value of
Stock
After Risky Investments
Wealth Transfer
Asset Substitution Problem
With risky debt, stockholders can gain even if the new, risky project has a negative NPV.
This happens as long as the debtholder’s loss exceeds the (negative) NPV of the project. Stockholders’ wealth declines by the (negative) NPV. Stockholders’ wealth increases by the loss of the
debtholders.
Asset Substitution Problem
Promised Payment to Debtholders
Total Firm Value
Promised Payment to
Debtholders
Market
Value
of Debt
Market
Value of
Stock
Before Risky Investments
Total Firm Value
Market
Value
of Debt
Market
Value of
Stock
After Risky Investments
Wealth Transfer
NPV < 0
Asset Substitution Problem
A levered position in common stock can be viewed as a call option on the firm’s assets.The exercise price of the call is the amount of money promised to the bondholders.If the option is “in the money,” the shareholders exercise their option and pay off the bondholders.If the option is “out of the money,” the shareholders elect not to exercise and default on the debt.A major determinant of the value of a call option is the riskiness of the value of the underlying assets.
Asset Substitution Problem
Consider the position of Stansfield Inc,.
They went into debt 10 years ago with an $800,000 zero coupon bond due in one year.
Bondholders trade the bond at $650,000 today.
Shareholders trade the firm’s equity at $30,000 today.
Asset Substitution Problem
The firm’s market value balance sheet today:
Assets Liabilities
$450,000$230,000$680,000
EquityDebtTotal
$30,000$650,000$680,000
CashAssetsTotal
Asset Substitution Problem
Today the firm projects that next year’s market value balance sheet with the investments in place today as:
Assets Liabilities
$450,000$400,000$850,000
EquityDebtTotal
$50,000$800,000$850,000
CashAssetsTotal
With the assets in place today, Bondholders will get $800,000 (out of a promised $800,000). Shareholders will get $50,000.
Required Returns
From today’s market prices we can infer the discount rates for the bondholders.Bondholders
$650×(1 + rd) = $800
rd = 23.08%Shareholders
$30×(1 + re) = $50
re = 66.67%
Asset Substitution Problem
The new management is considering the following investment:
CF0 = –$650,000 (This represents all of the firm’s cash, $450,000, plus $200,000 of the assets in place.)
In one year, the project either pays a 50% return or nothing.
E[CF1] = .5×$975,000 + .5×$0 = $487,500
Asset Substitution Problem
Assets Liabilities
$0$1,175,000$1,175,000
EquityDebtTotal
$375,000$800,000
$1,175,000
CashAssetsTotal
Assets Liabilities
$0$200,000$200,000
EquityDebtTotal
$0$200,000$200,000
CashAssetsTotal
In one year, if the bet wins, the balance sheet looks like this.
In one year, if the bet fails, the balance sheet looks like this.
Asset Substitution Problem
Consider the nature of the expected payoffs:
ShareholdersE[CFSH] = .5×$375,000 + .5 ×$0 = $187,500
BondholdersE[CFBH] = .5×$800,000 + .5 ×$200,000 = $500,000
Total FirmE[CF] = [.5×$975,000 + .5 ×$0] + $200,000 = $687,500
Asset Substitution Problem
We can estimate the value of the debt and equity after the management undertakes the risky investment:Shareholders
Bondholders
Total Firm: $406,250 + $112,500 = $518,750
500,112$67.1
500,187$EquityV
250,406$2308.1
000,500$DebtV
Asset Substitution Problem
Total Firm Value
$680,000
Market
Value
of Debt
$650,000
Stock $30,000
Before Risky Investments
Total Firm Value $518,750
Market
Value
of Debt
$406,250
Market
Value of
Stock
$112,500
After Risky Investments
243,750
NPV = –$161,250 = $518,750 – $680,000
Should We Take a Negative NPV project?
Do you think that the management of the firm has an ethical obligation to the shareholders to take $243,750 from the bondholders so that they can give $82,500 to the shareholders?
By the way, the NPV of the project is
–$161,250 = $82,500 – $ 243,750
The Underinvestment Problem
With risky debt outstanding, if stockholders gain from an increase in the risk of the firm’s investments, they lose from a decrease in the risk of the firm’s investments. Value of an option declines as the risk of the
underlying asset decreases.
Thus, stockholders may refuse to invest in a low-risk but positive NPV investment.
The Underinvestment Problem
Total Firm Value
Promised Payment to Debtholders
Market
Value
of Debt
Market
Value of
Stock
After Low-Risk InvestmentsTotal Firm
Value
Promised Payment to
Debtholders
Market
Value
of Debt
Market
Value of
Stock
Before Low-Risk Investments
Wealth Transfer
NPV > 0
Claim Dilution Problem
Claims of existing debtholders can be diluted in two ways: via dividend policy via new debt
Dividend Dilution
In the previous example, what if the board declared a $450,000 cash dividend today?
Dividend Dilution
The balance sheet would change from
Assets Liabilities
$450,000$230,000$680,000
EquityDebtTotal
$30,000$650,000$680,000
CashAssetsTotal
ToAssets Liabilities
$0$230,000$230,000
EquityDebtTotal
$0$230,000$230,000
CashAssetsTotal
A General Formula
Sources ≡ Uses
NOI + New Security Issues ≡ Dividends + Investment
T
tt
T
tt
T
tt DFSEkD
000
Claim Dilution via Dividend Policy
Paying out cash dividends has two effects: It reduces the firm’s cash and its owner’s equity. It increases the risk of the remaining assets (since cash
is riskless).
Reduction in owner’s equity enlarges the firm’s proportion of debt financing. This increases the risk of the debt, and decreases its
value.
Increase in the risk of the firm’s assets also increases stockholder wealth.
Claim Dilution via New Debt
Newly issued debt can reduce the chance that existing debtholders will be paid the promised amount. This occurs if the new debt’s claims are at least as
senior as the old debt’s claims.
This increased risk of existing debt reduces its value.
Stockholders get the benefit from this decline in value.
Consumer-Firm Conflicts
These can be of two types, depending on who is the agent and who is the principal. Guarantees and Service after Sale The Free Rider Problem
Guarantees and Service After Sale
The firm is the agent, and the consumer is the principal.
If the principal does not expect the agent to fulfill its promise, it will not pay full value for the firm’s products and services.
The Free Rider Problem
The firm is the principal and the consumer is the agent.
The agent has the option to duplicate the firm’s products/services at a lower cost.
Examples include copying of computer software, books, videotapes etc.
Copyright laws are designed to protect and encourage the development of valuable ideas.
Practical Contractual Considerations
Financial Distress Financial distress increases the conflicts between the
various stakeholders of the firm. Firms in financial distress have a greater incentive to
engage in asset substitutions and underinvestment - they have little to lose, and a lot to gain.
Stakeholders may form coalitions to act in their best interest, even though these actions may conflict with shareholder interests.
Practical Contractual Considerations
Financial contracts are complex because they involve imperfect information.
Agents may send “noisy” signals so as not to reveal their hand.
Well designed contracts can lead to more credible signals.
Mitigating Stockholder-Manager Conflicts
Agents with good reputation can demand higher prices for their products / services.
Management contracts can include monetary incentives: Stock options Performance shares Bonuses
Threat of takeovers and replacement can induce managers to act in shareholder interests.
Mitigating Debtholder-Stockholder Conflicts
Debtholders may restrict wealth appropriating behavior on the part of stockholders through debt contracts.
An indenture is the explicit legal contract for a publicly traded bond.
The indenture contains covenants: Negative covenants restrict certain actions of the firm. Positive covenants require certain actions on the part of
the firm.
Mitigating Debtholder-Stockholder Conflicts
Covenants benefit the bondholders by lowering the risk of the bonds.
They also benefit the stockholders since the reduced risk of the bonds implies lower interest rates.
Covenants can be costly to the stockholders: Reduces the firm’s operating flexibility. Monitoring costs must be paid to ensure that the
covenants are adhered to.
Mitigating Debtholder-Stockholder Conflicts
Convertible Bonds These can be exchanged for a pre-specified
number of shares of the firm’s common stock, at the bondholder’s option.
Bondholders can benefit from the up-side potential of successful risky investments.
Monitoring Devices
New External Financing When a firm seeks new external financing, it is
subject to special scrutiny. The willingness of investment bankers to
underwrite the issue acts as a certification device.
Firms that frequently raise capital from external sources are monitored more efficiently.
Monitoring Devices
Other devices include: Financial statements and auditor’s reports Cash dividends Bond ratings Government regulation Reputation effects Multilevel organizations