Corporate Financial Management chapter

A principal-agent relationship is a relationship where an agent makes decisions that affect the principal. Examples of explicit principal-agent relationships are the relationships between a client and a lawyer and between an investor and a money manager. Examples of implicit principal-agent relationships are an employee acting on behalf of its employer and a consumer making decisions, such as copying and selling a product, that can affect a manufacturer. . The asset substitution problem occurs when riskier assets are substituted for the firm’s existing assets. This problem can occur because the shareholders have the option to default on debt. In essence, the shareholders can gamble with the debtor’s’ money by substituting existing assets for high risk assets. Debtor’s are not compensated for the additional risk, and the stockholders gain at the expense of the debtor’s. If the risky assets result in a large payoff, the shareholders benefit because the debtor’s’ payments are fixed.

If the risky assets fail, the debtor’s will lose their investment. Because of the potential for shareholders to gain at the risk of the debtor’s, asset substitution results in an expropriation of wealth from debtor’s to stockholders. 3. The underinvestment problem is essentially the mirror image of the asset substitution problem. With underinvestment, stockholders refuse to undertake a good (positive-Wv’), but low-risk, investment because if they made the investment it would shift wealth to the debtor’s at the stockholders’ expense.

The wealth shift would be caused by increasing the chances that the debtor’s will be fully repaid (I. E. The low-risk investment would reduce the chance of bankruptcy). This occurs whenever a low-risk investment’s positive NP is not large enough to overcome the wealth shift from stockholders to debtor’s that would come with the investment. 4. A moral hazard is an opportunity for an agent to take unobserved actions for personal benefit to the detriment of the principal. A free rider is one who receives benefit from someone else’s expenditure simply by imitation.

One free-rider problem is the copying of pharmaceuticals. Drug companies spend hundreds of millions of dollars on research and development to discover new rugs. Other drug firms are able to duplicate the drug and produce it themselves, without the research and development costs. In the United States, patents protect pharmaceutical companies for a limited time from facing competition from the free- riding firms. 6. An agency problem is a potential conflict of interests between the agent and the principal. One agency problem is the ability of an employee to slack off during working hours.

Another agency problem is the ability of a manager to make the decision to grow a company to a large size rather than maximizing shareholders’ wealth. Another agency problem is the ability of the stockholders to gamble with the bondholders’ money by means of asset substitution. 7. Managers may have the goal of increasing the size of a firm to increase their own power and wealth rather than the shareholders’ wealth. Another goal of the managers may be to receive extensive perquisites such as a company car, expense accounts and a large office at the expense of the shareholders.

Also, managers may have the goal of enjoying their work time and shirking their responsibilities to the shareholders. 8. Agency costs are the costs of making agents act in the best interest of the principal. The components are direct contracting costs, monitoring costs, and the misbehaver costs of agents not acting in the best interest of the principal. An example of direct contracting costs is an employee bonus. An audit is an example of a monitoring cost. Shirking by employees is a cost caused by agents not acting in the best interest of their employer. 9.

Asset uniqueness can cause an agency cost to shareholders because they have to pay employees a risk premium for their specialized talent that is not valuable to other employers. Shareholders also would have to pay a higher interest rate to potholders for bearing the risk of accepting the unique assets as collateral. 10. Employee perquisites create a conflict between the employees and the controllers Decease employees can use a company car or an expense account Tort their own personal business instead of for the intended use of conducting the firm’s business. Chapter 14, Page 1 of 7 1 1 .

Product and service guarantees can create an agency problem between a consumer and a firm because the firm has the option to default and not honor the guarantee. 12. One device that naturally monitors an agent’s behavior is the right of the principal to fire the agent. Another natural device that monitors a manager’s behavior is the threat of a takeover. The shareholders’ right to elect the new directors who monitor manager behavior is a third device. Incentive compensation can be an effective monitor because it aligns the goals of the agent and the principal.

The legal system also acts as a monitor on an agent’s behavior. A multilevel organization is also a natural monitor of agents as employees work hard to earn promotions. The shareholders’ right to sell their shares because a lower share price can be signal that managers are not doing a good Job. 13. An optimal contract is a contract the minimizes total agency costs by balancing contracting, monitoring, and misbehaver costs. 14. Bond covenants help reduce agency costs because they are a cost-effective method of monitoring the financial status of the firm.

Also, bond covenants can protect bondholders against the agency problem of asset substitution. The reduced monitoring costs and the reduction in risk can result in a lower cost of borrowing for the firm. 15. Debtor’s require a restriction on the firm’s ability to issue new debt because debt issuance can dilute their claim on the firm and increase their risk. Two common covenants are that a firm must maintain a certain debt to asset ratio or a certain interest coverage ratio. 16. Common stockholders may view their equity as a call on the firm’s assets written to them by the debtor’s.

Stockholders may accept a negative-NP project to increase the risk of the firm, thus causing the value of their call option to rise. This is the asset substitution problem. 17. If stockholders view their equity as an option on the firm’s assets (written to them by the debtor’s), stockholders might reject a positive-NP project. This is because he project would decrease the risk of the firm, and cause the value of their option to fall by more than the project’s NP. The debtor’s would get the difference that the stockholders would lose. This situation is the underinvestment problem. 8. Claim dilution reduces the debtor’s’ value by increasing the ratio of debt to the value of the assets supporting the claim. Claim dilution via dividends increases this ratio by reducing the value of assets supporting the debt. Claim dilution via new debt increases this ratio by increasing the both the amount of debt and the amount of assets. Limited liability gives stockholders an option on the firm’s assets (written to them by the debtor’s), so the increase in risk (higher debt ratio) increases the value of their option and decreases the debtor’s’ value. 19.

By making a manager a stockholder, conflicts of interests can be reduced because the goals of the manager Ana toner stockbrokers will De more scalar. I T ten manager acts In ten Test Interest of the stockholders, he is also acting in his own best interest. 20. Throughout a career, a person learns many things connected with that career, and especially things connected with his or her employers. If the industry shrinks or disappears (such as certain manufacturing Jobs in the U. S. ), the person may not have a good alternative place to work that would use the things they have learned over their career.

Essentially, their human capital is not very well diversified. It is instead focused on particular industries and employers. This is very different from a person’s financial capital, which can be invested in many different industries and firms. The lack of diversification in human capital causes goal divergence between employees with their human capital and stockholders with their financial capital. 1 . Stockholders diversify their financial investment in the firm, and therefore care only about non-diversified risk.

Employees’ human capital is hard to diversify, and they care about the firm’s total risk because they bear diversified and non- diversified risk. This can cause a conflict of interest because employees will prefer diverse capital investments that limit their risk, while shareholders prefer the highest-NP investments, even if the investment has very high total risk. Chapter 14, Page 2 of 7 22. An agent’s good reputation has an implicit guarantee of good performance, cause of which the agent can get higher wages and promotions.

The agent’s cost of misbehaving can be high because misbehaver can ruin the agent’s reputation and cause the agent to forego higher wages, or even lose his or her Job. The reputation facilitates monitoring because the agent is less likely to misbehave if the cost to their reputation is large. 23. In financial distress, the bondholders’ claim on the firms’ assets is contingent to default. Financial distress can intensify the conflict of interests between shareholders and bondholders because of the probability of the warehouses losing control of the firm and their investment.

Shareholders may engage in asset substitution and underinvestment, seek new loans, and fight protracted court battles to keep their equity. 24. The stock price of firm in bankruptcy is never negative because of the limited liability of equity. The stock price is always positive because the stock represents an option on the firm’s assets, and an option’s value cannot be negative. Challenging Questions 25. Incentive compensation is a common method used by shareholders to align the goals of a manager with their own.

Another method is the stockholders’ ability to elect directors and the directors’ ability to fire a manager. Also, the threat of takeover can align the goals of a manager to those of the stockholders because shareholders have the right to sell the stock of a poorly performing firm. 26. Monitoring is not always the best choice because the cost of monitoring may exceed the expected misbehaver costs. If the cost of monitoring is more than the expected misbehaver costs, monitoring would not provide the optimal contract 27. A firm should not generally use the most restrictive set of covenants.

Rather it should SE ten set AT covenants Tanat proposes ten lowest total cost, Including opportunity costs. The most restrictive set of covenants would have a number of overlapping covenants. This is like the value of overlapping options which can be less than the sum of individual option values. The overlapping covenants may not provide the bondholders any added protection but may cost the firm a lot of flexibility. A covenant restricting new business lines may prevent the firm from undertaking a positive-NP project with greater value than the firm gained from lower interest rates associated with the covenants.

The firm may lose valuable options, such as the option to undertake a new project, because of the restrictive covenants. 28. Agency problems result because of asymmetric information. If there was no asymmetric information, the principal would know everything the agent does and the agent would not take any actions that were not in the best interest of the principal. That is why perfect monitoring eliminates agency problems. 29. The shareholders can resist any settlement and inflict costs on the debtor’s. Essentially, the shareholders have the “option to make trouble. The debtor’s sometimes “purchase” this option y making a payment to the shareholders and avoiding a costly and lengthy legal battle, thereby enabling them to get their money earlier and avoid higher legal fees. 30. A debtors should be concerned about a firm’s dividend policy. A firm could pay a large dividend to its shareholders, causing a reduction in the owners’ equity and an increase in the percentage of debt financing of the assets. The debt would then be riskier and its value would fall. 31 . Employee perquisites could create an agency problem between managers and debtor’s if there was little or no stockholders’ equity.

If a company was operating n bankruptcy and the stockholders’ equity was zero, the managers would be funding their perquisites with the debtor’s’ money. 32. A multilevel organization can provide a form of agent monitoring through the use of promotion. Employees with the best reputations will be the agents that are promoted through the levels of the corporation. Agents with good reputations are unlikely to misbehave because the cost of misbehaving is high. Other agents will mimic the agents with good reputations hoping to be promoted to higher positions with higher pay. 3. A convertible bond can reduce the agency problem between the shareholders and potholders because it helps to align the goals of both parties. The debtor’s can share in the upside potential of the firm by converting their bonds to common stock. Stockholders are not the only ones who stand to benefit through the firm’s risky behavior, the debtor’s can benefit as well. Chapter 14, Page 3 of 7 34. It should be possible to predict what claimant coalitions will form during a financial distress because of the Principal of Self-Interested Behavior.