Reading: Conflicts between Stockholders and Creditors
Agency
Conflicts
•An
agency relationship arises whenever someone, called a principal, hires 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
(1) stockholders and creditors
(2) inside owner/managers (managers who own a controlling interest in the company) and outside owners (who have no control)
(3) outside stockholders and hired managers.
(1) stockholders and creditors
(2) inside owner/managers (managers who own a controlling interest in the company) and outside owners (who have no control)
(3) outside stockholders and hired managers.
•These
conflicts
lead to agency costs, which are the reductions in a company’s value due to
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 bankruptcy.
•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.
Perceived
Credit Risk
•Creditors
lend funds at rates based on the firm’s perceived risk at the time the credit
is extended.
•Perceived
credit risk is
based on
(1) the risk of the firm’s existing assets
(2) expectations concerning the risk of future asset additions
(3) the existing capital structure
(4) expectations concerning future capital structure changes.
(1) the risk of the firm’s existing assets
(2) expectations concerning the risk of future asset additions
(3) the existing capital structure
(4) expectations concerning future capital structure changes.
•These
are
the primary determinants of the risk of the firm’s cash flows, hence the safety
of its debt.
Asset
Switching
•Example:
A firm borrows
money, then sells its relatively safe assets and invests the proceeds in assets
for a large new project that is far riskier.
•The
new
project might be extremely profitable, but it also might lead to bankruptcy. If
the risky project is successful, most of the benefits go to the stockholders,
because creditors’ returns are fixed at the original low-risk rate.
•If the
project is unsuccessful, the bondholders take a loss. From the stockholders’
point of view, this amounts to a game of “heads, I win; tails, you lose,” which
obviously is not good for the creditors.
•The
increased
risk due to the asset change will cause the required rate of return on the debt
to increase, which in turn will cause the value of the outstanding debt to
fall. This is called asset switching or “bait- and-switch.”
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.
•If
things
go well, the stockholders will gain from the increased leverage.
•However, the
value of the debt will probably decrease, because now there will be a larger
amount of debt backed by the same amount of assets.
•In
both
the asset 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.
•However, if
the company doesn’t increase risk, then its weighted average cost of capital
(WACC) will be higher than is justified by the company’s risk. This higher WACC
will reduce the company’s intrinsic value (recall that intrinsic value is the
present value of free cash flows discounted at the WACC).
•In
addition,
the company will reject projects that it otherwise would have accepted at the
lower cost of capital. Therefore, this potential agency conflict has a cost,
which is called an agency cost.
How
Lenders Address Asset Switching
•The
second way that lenders address the potential agency problems is by writing
detailed debt covenants specifying what actions the company can and cannot
take.
•Many debt
covenants have provisions including:
(1) prevent the company from increasing its debt ratios beyond a specified level
(2) prevent the company from repurchasing stock or paying dividends unless profits and retained earnings are above a certain level
(3) require the company to maintain liquidity ratios above a specified level.
(1) prevent the company from increasing its debt ratios beyond a specified level
(2) prevent the company from repurchasing stock or paying dividends unless profits and retained earnings are above a certain level
(3) require the company to maintain liquidity ratios above a specified level.
•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 in the bond covenant.
•In addition,
the costs incurred to write the covenant and monitor the company to verify
compliance also are agency costs.
Last modified: Tuesday, August 14, 2018, 8:53 AM