© Prentice Hall, 2004 14 Corporate Financial Management 3e Emery Finnerty Stowe Agency Theory.

© 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