Lecture 6

Question 1

What is the Agency Cost of Debt?

Answer 1

Managers try to maximise shareholder wealth, even if this destroys the firm value:
- Over-investment (asset substitution): firm faces financial distress, shareholders can gain profits at the expense of debt holders by taking excessive risk, even if it is a negative-NPV project and destroys value for the firm overall.
- Under-investment (debt overhang): firm faces financial distress due to too much debt, it may choose not to finance new, positive-NPV projects.
- The firm may even sell assets and pay large cash dividends to shareholders as a further step of underinvestment → Milking the property = selling the family silver

Question 2

What is the Agency Cost of Equity?

Answer 2

Separation of ownership and control: shareholders can’t fully observe managers’ actions, managers seek to maximise private utility at shareholders’ expense:
- Empire building: increasing firm size (and their pay), instead of profitability
- Wasteful investment: taking negative NPV projects when firms have high levels of Free Cash Flow
- Managerial perks: maximizing personal benefits via bonuses, cars…
- Shirking: putting less efforts
- Shareholders also incur costs by monitoring managers

Question 3

How does leverage increase the Agency Costs of Debt?

Answer 3

• Encourage stakeholders to act in ways that reduce firm value via over- and under-investment.
• Anticipating the problem, creditors (debtholders) may require higher interest rates or place debt covenants (restrictions on firms’ actions)

Question 4

How does leverage increase the Agency Costs of Equity?

Answer 4

• Adds discipline to managers by committing the firm to making future interest payments, and thus decreases the moral hazard issue => more debt = more interest payments => less likely to spend capital inefficiently
• This is also called the Agency Benefits of Debt

Question 5

What is Financial Distress?

Answer 5

• Firm’s operating cash flows are not sufficient to satisfy current obligations (such as trade credits or interest expenses) and the firm is forced to take corrective actions.
• Financial Distress DOES NOT EQUAL Bankruptcy, shortfall in cash to pay current liabilities

Question 6

What are the possible strategies for a firm in financial distress?

Answer 6

• Asset expansion policies: reduce the risk of its operations, firm can engage in acquisitions, new joint ventures, higher levels of production
• Operational contraction policies: Firm can focus on the most profitable operations while closing down other divisions
• Financial policies: To increase the cash liquidity, firm reduce the dividends and/or restructure existing debt and pay less interest
• External control activities: Shift of ownership to other big investors
• Change in managerial control: Ex: Former CEO of Royal Bank of
  Scotland after a failing acquisition of Dutch Bank in 2007
• Wind up company: Least desirable strategy → Bankruptcy