FINS5514: Capital Budgeting and

Financing Decisions

Lecture 1: Overview and Agency Theory

 Topics Covered Today
_______________________________________________________________________________

• Objectives of the firm

• Agency theory
• Asymmetric Information/ Signaling

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• Financial managers make 3 broad decisions:
– Investment (Capital budgeting)
– Financial (Capital structure)
– Dividends
• All decisions theoretically separate but practically
interwoven

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 Investment Decision
_______________________________________________________________________

• Decisions that create profit and revenue, as well as

those that reduce costs and expenses
• Bottom line is to increase firm value
• What long-term investments or projects should the
business take on?
• Capital budgeting analysis is therefore necessary to
incorporate:
– Risk of cash flows
– Timing of cash flows

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The balance-sheet model of the firm

Assets Liabilities/Shareholders’ equity

Current
liabilities
Current
assets Long-term
debt

Fixed assets:
- tangible
Shareholders’
- intangible equity

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The capital budgeting decision
Assets Liabilities/Shareholders’ equity

Current
liabilities
Current
assets Long-term
debt

Fixed assets:
What long-term
- tangible investments Shareholders’
should the firm
- intangible equity
engage in?

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 The capital budgeting decision - examples

Project 1: cash flows of the project

Date 0 1 2 3
CF -100 5 5 110

Project 2: cash flows of the project

Date 0 1 2 3 4 5
CF -100 5 5 5 5 110

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 Financing Decision
_______________________________________________________________________

• How to raise additional funds to invest:

– Debt
• Straight or convertible
• Long or short term
• Fixed or floating rate
– Equity
• Ordinary or preference shares
• Choice depends upon:
• Tax implications, External monitors, Firm risk, Matching,
Signaling, Agency Theory
• Capital structure
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 Capital structure

Assets Liabilities/Shareholders’ equity

Current
liabilities
Current
assets Long-term
debt
How can the firm
raise the money
for the required
Fixed assets:
investments?
- tangible
Shareholders’
- intangible equity

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 Firm Objective
_______________________________________________________________________

• What should be the goal of a corporation?

– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s stock?

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• Corporate wealth maximisation (CWM):
– Satisfy all stakeholders in firm, including:
• Debtholders
• Employees
• Society
– This model is used in Germany and Japan
• Shareholder wealth maximisation (SWM)
– This is the most popular answer
– Main objective of the firm is to maximize shareholder
value
– Equivalent to increase share price if listed
– Ethical issues : shareholders may expropriate wealth from
other stakeholders

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 The Agency Problem
_______________________________________________________________________

• Under SWM, managers should be concerned only with

the shareholders’ welfare, but are they?
• Agency relationship
– Principal hires an agent to represent his/her interest
– Stockholders (principals) hire managers (agents) to run the
company

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• Jensen & Meckling (1976) state that the firm is a nexus
of contracts
• All stakeholders of the firm are concerned only with self-
interest
• This creates conflicts of interest between:
– Shareholders and managers
– Shareholders and debtholders

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 Agency Conflicts - Shareholders/Managers
_______________________________________________________________________

• Managers prefer to:

– Increase their job security
– Increase their own power and status
– Consume excessive perquisites
• They may do this at the expense of SWM

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• Shareholders know this, and therefore attempt to
protect against it by:
• Linking managerial salaries to firm performance
• Limit the free cash flows under managerial discretion
• Monitor managers through, for example, audits or tighter
shareholder concentration
• All of the activities of shareholders to decrease agency
conflicts occur at a cost, called, agency costs.
– Changes in policy
– Opportunity costs if managers unable to invest in positive
NPV projects
– Monitoring costs

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Other mechanisms:

• The Board of Directors

– Employing independent directors on the Board.
• The market for corporate control (mergers and
acquisitions) can use used to solve the agency
problem
– Shareholders can threaten to sell their shares in a hostile
takeover
– If the takeover goes ahead, the firms managers are likely to
be fired afterwards.
– This is viewed as the “court of last resort” (Jensen 1988)

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 Agency Conflicts - Shareholders/Debtholders
_______________________________________________________________________

• Asset substitution:
• Managers switch/substitute higher risk for lower risk projects
on debtholders
– invest in assets that are riskier than what bondholders want
– debtholders have a fixed claim while shareholders have a
residual claim on the firm
– Shareholders prefer to invest in riskier project (greater risk,
greater return).
– increases risk that bondholders will bear due to increased risk
of bankruptcy.

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• Agency Costs
– Debtholders protect themselves through covenants, by
charging higher interest rates, or refusing to deal with the
firm => bad for s/h

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 Types of Agency Problems
_______________________________________________________________________

• Moral Hazard(HiddenAction)
– Although the principal and the agent have the same initial set
of information, the principal cannot observe the action chosen
by the agent

• AdverseSelection (Hidden Information)

– Both the principal and the agent know that the agent has
information which is valuable to the principal but which the
principal cannot see

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 Asymmetric Information/ Signaling
_______________________________________________________________________
• One potential cause of agency problems is
asymmetric information
• Managers have more info than outsiders, including
shareholder and debtholders
– Akerlof (1970) market for lemons
– With no signals, markets break down – sellers will not
sell, buyers will not be able to buy

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• He used the market for second hand cars as an
example
– Twotypes of secondhandcars
– Lemons– poor quality carswhich are worth$400
– Peaches– good quality carswhich are worth $2,000
– Each type of carrepresents 50%of themarket

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• There are 3 scenarios to consider
• Peaches and lemons can be accurately
identified by everyone in the market
– Here is there is no problem because everyone
has all the necessary information.
– Cars will be sold at their correct values and the
market will continue to operate
– A peach will be sold for $
and a lemon for $

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• No-one knows whether any particular car is a
peach or a lemon
– Assuming risk neutrality, buyers will work out
what they are prepared to pay:
E(Value) = Proportion of lemons x Value of lemon
+ Proportion of peaches x Value of peach
– In this example, this is:

– So, all cars will sell at $

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• Asymmetric information in which the sellers
know the quality of the car but buyers do not.
– Here the market will break-down

– Sellers of good cars will only accept $

but buyers will not pay more than $

– Therefore, no good cars will be sold and the only

cars on the market will be lemons

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• Solutions:
– Buyers gain their own skills => costly
– Sellers signal that their cars are not lemons, by:
• Warrantees
• Trial periods
– Effective signals are:
• Costly
• Credible
• Unambiguous
• Cannot be mimicked
– Consequently, a mere statement by the sellers that the car is
good is not an effective signal
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• The same as the market for lemons, managers will
attempt to signal to investors that the firm is not a
lemon.
• Briefly, this may be done through corporate
announcements, such as:
– Dividends
– Capital restructuring
– Takeover plans
– Initial Public Offerings

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 CorporateGovernance
_______________________________________________________________________

• Name for any measures that can be used to close the

incentive gap between managers and shareholders
and reduce agency problems
• Some firm level solutions are on the previous slides
• To illustrate why this is important, consider a
situation where governance failed:
– The collapse of Enron (see reading and tutorial questions)

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 Country LevelCorporateGovernance
_______________________________________________________________________
• Corporate governance also exists at a country
(macro) level
• E.g. Sarbanes-Oxley Act (2002), Dodd–Frank Act
(2010)
• These regulations try to encourage / force firms to
act in the best interests of their shareholders
• However, is difficult to get the balance correct
between enforcing good governance and still
allowing firms to evolve and react to changing
situations

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 The firm and the financial markets
______________________________________________________________________

Firm Firm issues securities (A) Financial

markets
Invests Retained
in assets cash flows (D)
(B)
Short-term debt
Current assets Cash flow Dividends and Long-term debt
Fixed assets from firm (C) debt payments (F)
Equity shares

Ultimately, the firm
must be a cash
generating activity.
Taxes (E)
The cash flows from
the firm must exceed
Government the cash flows from the
financial markets.
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 Financial markets
_______________________________________________________________________

Money markets versus capital markets:

• Money markets:
– For short-term debt instruments.
• Capital markets:
– For long-term debt and equity.

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Primary versus secondary markets:
• Primary market:
– When a corporation issues securities, cash flows from
investors to the firm.
– Usually an underwriter is involved.
• Secondary markets:
– Involve the sale of “used” securities from one investor to
another.
– Securities may be exchange traded or traded over-the-
counter in a dealer market.

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 Financial markets
_______________________________________________________________________

Stocks and
Bonds Investors
Firms securities
Money Bob Sue
money

Primary Market
Secondary
Market

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 Summary
_______________________________________________________________________

• Three important questions in corporate finance

Capital budgeting
Capital structure
Dividends
• The goal of the corporation
Maximize shareholder’s value
• Agency problems
• Financial markets

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