Video Transcript: Conflicts Between Stockholders and Creditors

hello, welcome. We're going to discuss the conflicts between stockholders and  creditors. These are known as agency conflicts. An agency relationship arises  whenever someone called a principal hire. Someone else called an agent to  perform some service and the principal delegates decision making authority to  the agent in companies. The primary agency relationships are between one  stockholders and creditors, two inside owner managers, managers who own a  controlling interest in the company, and then the outside owners. Right? So the  inside ownership managers and then the outside owners, they may have a  conflict, because they can see the company going in different directions.  Number three, outside stockholders and hired managers. So outside  stockholders, they want to always push for greater returns, greater returns,  maximize shareholder value, whereas hired managers on the inside may see  operations a little bit differently and may not want to be so aggressive, because  they know that they have to build up their business and continue to define and  become experts in the skills of their industry, these conflicts lead to agency  costs, which are the reductions in a company's value due to these agency  conflicts, stockholder creditor conflicts. Creditors have a claim on the firm's  earnings stream, and they have a claim on its assets in the event of a  bankruptcy. Remember, creditors are lenders. They are the ones that are issuing our debt. So they have a claim on the firm's earning streams first above  shareholders, right? You can see how this can create a conflict between the  lender and the stockholder. Now, stockholders have control through the  managers of decisions that affect the firm's riskiness. Therefore, creditors  allocate decision making authority to someone else, creating a potential agency  conflict, because managers are also invested into the company and are, more  than likely, shareholders themselves. Decisions that can be positive for  stockholders can be driven through managers, which may create a higher level  of risk because of the aggressiveness of operations, growth, because managers and stockholders want to see their stock price appreciate, and you may take on  additional risk in order to push the envelope, To push your stock price higher.  Now, lenders are risk averse because they want to see a stable, smooth  operation. They want to know that they have a steady stream of income. That  way they know that they'll get repaid. So you can see how the aggressiveness  that leads to additional risk by the stockholders can be a conflict between them  and the lender perceived credit risk. Creditors lend funds at rates based on the  firm's perceived risk at the time the credit is extended. So perceived risk? How  are they perceived as risky? How credit worthy are they? Will they be able to  repay these funds if we have a downturn in their industry, or if they stumble out  of the blocks and something happens and and they have to pay out extra  capital, are they going to be able to cover their debt obligations? So we want to  know, as a lender, as a creditor, are the credit worthiness of this individual or this company worthy of receiving funds from the lender. So perceived credit risk is 

based on the risk of the firm's existing assets, two expectations concerning the  risk of future asset additions. So growing the asset base, more capital  expenditures, more property, plant equipment, the existing capital structure,  right? So is there too much debt to equity already? How highly leveraged are  they? Are they 80% debt, 20% equity, very highly leveraged. Leverage is known  as over how much debt do we have? Are we overextended? Do we have too  much debt? Are we over levered? Right? They want to know that your capital  structure is efficient. So adding more debt would create extra risk, particularly  default risk. So we should know the existing capital structure and if it works for  us, if we're the lender, expectations concerning future capital structure changes  as a lender, we need to know, how are they going to forecast their future capital  structure? Are they going to keep it intact? Will they pay down debt? Will they  issue more equity that is all in perceived credit risk? These are the primary  determinants of the risk of the firm's cash flow. Hence the. Safety of its debt. We want to make sure that anyone that borrows from the lender is able to repay and not be too much of a default risk. So asset switching. Let's discuss asset  switching. Example, a firm borrows money then sells its relatively safe assets  and invest the proceeds and assets for a large new project that is far riskier. The new project might be extremely profitable, but it might also lead to bankruptcy  again. Are they going for too much operations growth or getting too far ahead of  themselves? So do they have a opportunity for failure with this new expansion?  Okay, if the risky project is successful, most of the benefits go to the  stockholders, right? Because the stock price is going to appreciate, therefore  they're going to have higher dividend payments, right? But the debt holders,  right? The lenders, they aren't going to participate into this new highly, extremely profitable success of the company, right? Because they have a steady, fixed  stream of income coming from our borrowers, right? So they're not going to  really see any advantage from this extended risk, right? So if the project is  unsuccessful, the bondholders will take a loss, because there's a high  probability that this company will have to go through some type of bankruptcy  restructuring or potentially even a liquidation, which is very risky for the  bondholders, right from the stockholders point of view, the amounts of a game of heads, I win, tails, you lose, is obviously not good for the creditors, because if  we invest in this risky project that's going to promote extreme profit and growth,  right, as a stockholder. Look, I have nothing to lose here, right? I have I can lose my investment right in the share price, but I can share. I can sell those shares  and recoup those, at least a portion of the proceeds of those shares whenever I  want. Whereas debt holders, they may be left out to dry, let's say there's  liquidation that goes on, and they're only to be able to recover 10 cents on the  dollar right of their assets, right? So you've got to make sure that stockholders  aren't pushing the envelope and trying to implement too much risky growth. The  increased risk due to the asset change will cause the required rate of return on 

the debt to increase. So as a company exposes themselves to more risk in the  market, obviously, creditors will adjust their cost of lending and raise their  interest rates as they deem the company more risky, the increased risk due to  the asset change will cause the required rate of return on the debt increase,  which will in turn cause the value of the outstanding debt to fall. This is called  asset switching, or bait and switch right increasing leverage. A similar situation  can occur if a company borrows and then issues additional debt, using the  proceeds to repurchase some of its outstanding stock, thus increasing its  financial leverage. So a company borrows and then issues additional debt, so it  uses proceeds to go out into the market and repurchase some of its outstanding stock. So they went. So they so this company goes out into the market, issues  more debt, borrows more money, goes into equity markets, buys their own stock back, right? So they just levered themselves to go buy their own stock. Okay? If  things go well, the stockholders will gain from the increased leverage. Why?  Because the company is going back into the market. They're repurchasing their  stock. When they repurchase their stock, it's going to push the stock price  higher. However, the value of the debt will probably decrease, because there  now will be a large amount of debt backed by the same amount of assets. So  their debt to equity ratio just increased, right? Because they just took on this  new debt to go back into the equity markets and buy back shares. So now,  because their debt to equity ratio is increased, right? Now their interest rate or  their cost of borrowing, right, will increase as well, because a bank or lending  institution will see them as more risky because they have a higher leverage  balance sheet, right? They have more debt on their balance sheet. So that way  that now that debt to equity ratio has grown larger, and then a bank or a lending  institution will notice that and factor it in as a default risk, and both the assets  switch. And the increased leverage situations, stockholders have the potential  for gaining, but such gains are made at the expense of creditors. How lenders  address asset switching? There are two ways that lenders address the potential  of asset switching or subsequent increases in leverage. First, creditors may  charge a higher rate to protect themselves in case the company engages in  activities which increase risk, so they're going to insulate themselves from this  increased risk by more than likely, providing a higher interest rate. What if the  company doesn't increase risk, then its weighted average cost of capital will be  higher. Then is justified by the company's risk, the higher weighted average cost of capital will reduce the company's intrinsic value. Recall that intrinsic value is  the present value of free cash flows discounted at the weighted average cost of  capital. Remember, our average weighted cost of capital, our weighted average  cost of capital is okay, our capital structure say 50% debt, 50% equity. Let's say  the debt is 12% they're getting an 8% return on their equity. They're both 50/50  so 10% would be our weighted average cost of capital. In addition, the company will reject projects that will otherwise would have accepted at the lower cost of 

capital. Therefore, this potential agency conflict has a cost, which is called an  agency cost. So now you can see that this company may not be able to take on  the additional risk, because some of the additional risk may be priced in by the  bank and the default risk. The second way that lenders address the potential  agency problem is by writing detailed debt covenants specifying what actions  the company can and cannot take. Many debt covenants have provisions,  including one prevent the company from increasing its debt ratios beyond  beyond a specific level. So a debt covenant is written in to a debt contract, and it specifies certain ratios, or different objectives that the company that borrows  must maintain or complete by, or they will have an opportunity to have their debt  called, or if they aren't meeting these obligations or these potential ratios, then  they will have additional borrowing costs tacked on until they get the ratios in  line prevent the company from repurchasing stock or paying dividends unless  profits and retained earnings are above a certain level, because debt holders  need to be will be repaid first if they're in the event of a bankruptcy, so a debt  lender may put in the provision that they cannot repurchase stock or pay  dividends unless profits and retained earnings are above a certain level,  because debt holders want to make sure that they're gonna they're gonna get  paid back from free cash flow in the event of a downturn or bankruptcy situation. These covenants can cause agency costs if they restrict a company from value  adding activities. For example, a company may not be able to accept an  unexpected but particularly good investment opportunity if it requires temporarily adding debt above the level specified and the bond covenant In addition, the  costs incurred to write the covenants and monitor the company to verify  compliance are also agency costs.