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.
•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.
•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.
•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