Agency Theory

14
Corporate Financial Management 3e
Emery Finnerty Stowe
© Prentice Hall, 2004
Principal-Agent Relationships

An agent has decision-making authority that

affects the well-being of the principal.
Examples of agents:
 Money managers
 Lawyers
 Corporate managers
Examples of principals:
 Investors in a money market fund
 Clients of lawyers
 Stockholders of the firm
Agency Problem

An agency problem arises when there is a conflict

of interest between the agents and the principals.
It can also arise due to asymmetric information:
 The principal cannot monitor the agent’s behavior
perfectly.
Moral hazard can occur when agents take actions
in their own best interest that are unobservable by
and detrimental to the principal.
The Role of Monitoring

The principal can monitor the agent’s actions, but

not perfectly.
Costs are incurred in monitoring the agent’s
behavior.
Perfect monitoring of all actions of the agent can
eliminate the agency problem.
 This can be prohibitively costly.
There is a trade-off between resources spent on
monitoring and the possibility of agent
misbehavior.
Alternatives to Monitoring

Alternatives to monitoring include:

 Constraints on agent’s behavior.
 Incentives to align agent’s interests with the
principal’s interests.
 Punishments for agent misbehavior.

Principal-agent contracts that eliminate all

agency problems cannot be designed.
 Thus, a residual agency problems remains.
Agency Costs

These are costs incurred in an attempt to push

agents to act in the principal’s best interest.
They are the incremental costs of working through
others.
They consist of three types:
 Direct contracting costs
 Monitoring costs
 Loss of principal’s wealth due to residual, unresolved
agency problems.
Direct Contracting Costs

Transaction cost of setting up a contract.

 e.g. Legal fees
Opportunity costs imposed by constraints that
preclude otherwise optimal decisions.
 e.g. Inability to take positive NPV projects due to
restrictive bond covenants.
Incentive fees paid to agents to encourage
behavior consistent with the principal’s goals.
 e.g. Employee bonuses.
Role of Financial Contracting

To design financial contracts between agents and

principals that minimize total agency costs.
Perfect contracts that eliminate all agency
problems are not feasible.
 Periodic misbehavior may be less costly than the cost of
eliminating it.
The optimal contract transfers decision-making
authority from the principal to the agent in the
most efficient manner.
Stockholder-Manager Conflicts

Created by the separation of ownership and

control of the corporation.
Stockholders elect the Board of Directors,
who in turn appoint managers.
The self-interested behavior of managers
may be at conflict with the interest of
stockholders.
Stockholder-Manager Conflicts

Managers may favor growth and larger size

of the firm:
 Greater job security
 Larger compensation

 Greater prestige

 Larger discretionary expense accounts

Stockholder-Manager Conflicts

Consumption of excessive perquisites.

 Direct benefits: use of company car, expense accounts.
 Indirect benefits: up-to-date office decor.
Shirking
 They may not put forth their best efforts.
Non-Diversifiability of Human Capital
 Managers’ expertise is closely tied to the firm.
 This leads to a divergence of goals.
Non-Diversifiability of Human
Capital
Capital Investment Choices
 Preference for low-risk projects even though their NPV
may be lower than other riskier projects.
 If the firm ceases to operate as a result of “bad”
outcomes of risky projects, managers lose their jobs.
Asset Uniqueness
 The more a manager’s human capital is closely tied to
the firm, the more unique the assets of the firm are.
Debtholder-Stockholder Conflicts

When a firm issues risky debt, stockholders

have an option against the debtholders.
 The option to default on debt.
Now, stockholders are the agents and the
debtholders are the principals.
 Debtholders want to protect themselves against
adverse decisions taken by stockholders.
Debtholder-Stockholder Conflicts

This conflict can manifest in three ways:

 Asset substitution
 Underinvestment

 Claim Dilution
Asset Substitution Problem

Occurs when riskier assets are substituted for the

firm’s existing assets.
 This appropriates wealth from the firm’s existing
debtholders.
Stockholders have the option to default on debt.
As the risk of the firm’s investments increases,
 the value of this option increases.
 the expected payment to debtholders decreases.
 Asset Substitution Problem
Before Risky Investments After Risky Investments
Total Firm Total Firm
Value Value
Market
Market
Value of
Promised Value of Promised
Payment to Stock Payment to
Debtholders Wealth
Stock Debtholders
Transfer
Market
Market
Value
Value
of Debt
of Debt
Asset Substitution Problem

With risky debt, stockholders can gain even if the

new, risky project has a negative NPV.
This happens as long as the debtholder’s loss
exceeds the (negative) NPV of the project.
 Stockholders’ wealth declines by the (negative) NPV.
 Stockholders’ wealth increases by the loss of the
debtholders.
 Asset Substitution Problem
Before Risky Investments After Risky Investments
Total Firm
Value NPV < 0
Market Total Firm
Value
Value of Market
Promised Promised
Payment to Stock Value of Payment to
Debtholders Debtholders
Wealth Stock
Transfer
Market
Value Market

of Debt Value
of Debt
Asset Substitution Problem
A levered position in common stock can be
viewed as a call option on the firm’s assets.
The exercise price of the call is the amount of
money promised to the bondholders.
If the option is “in the money,” the shareholders
exercise their option and pay off the bondholders.
If the option is “out of the money,” the
shareholders elect not to exercise and default on
the debt.
A major determinant of the value of a call option
is the riskiness of the value of the underlying
assets.
Asset Substitution Problem
Consider the position of Stansfield Inc,.
They went into debt 10 years ago with an
$800,000 zero coupon bond due in one year.
Bondholders trade the bond at $650,000
today.
Shareholders trade the firm’s equity at
$30,000 today.
 Asset Substitution Problem
The firm’s market value balance sheet today:

Assets Liabilities
Cash $450,000 Equity $30,000
Assets $230,000 Debt $650,000
Total $680,000 Total $680,000
 Asset Substitution Problem
Today the firm projects that next year’s market value balance
sheet with the investments in place today as:

Assets Liabilities
Cash $450,000 Equity $50,000
Assets $400,000 Debt $800,000
Total $850,000 Total $850,000

With the assets in place today, Bondholders will get $800,000

(out of a promised $800,000). Shareholders will get $50,000.
Required Returns
From today’s market prices we can infer the
discount rates for the bondholders.
Bondholders
$650×(1 + rd) = $800
rd = 23.08%
Shareholders
$30×(1 + re) = $50
re = 66.67%
 Asset Substitution Problem
The new management is considering the following
investment:
CF0 = –$650,000 (This represents all of the firm’s
cash, $450,000, plus $200,000 of the assets in
place.)
In one year, the project either pays a 50% return or
nothing.
E[CF1] = .5×$975,000 + .5×$0 = $487,500
 Asset Substitution Problem
In one year, if the bet wins, the balance sheet looks like this.
Assets Liabilities

Cash $0 Equity $375,000

Assets $1,175,000 Debt $800,000
Total $1,175,000 Total $1,175,000
In one year, if the bet fails, the balance sheet looks like this.
Assets Liabilities

Cash $0 Equity $0
Assets $200,000 Debt $200,000
Total $200,000 Total $200,000
 Asset Substitution Problem
Consider the nature of the expected payoffs:
Shareholders
E[CFSH] = .5×$375,000 + .5 ×$0 = $187,500
Bondholders
E[CFBH] = .5×$800,000 + .5 ×$200,000 = $500,000
Total Firm
E[CF] = [.5×$975,000 + .5 ×$0] + $200,000 = $687,500
Asset Substitution Problem
We can estimate the value of the debt and
equity after the management undertakes the
risky investment:
$187,500
Shareholders VEquity   $112,500
1.67

Bondholders $500,000
VDebt   $406,250
1.2308

Total Firm: $406,250 + $112,500 = $518,750

 Asset Substitution Problem
Before Risky Investments After Risky Investments
Total Firm
Value NPV = –$161,250 = $518,750 – $680,000
Stock $30,000 Total Firm
$680,000 Market
Value
Value of $518,750
243,750 Stock
Market
$112,500
Value
Market
of Debt
Value
$650,000
of Debt
$406,250
Should We Take a Negative NPV
project?

Do you think that the management of the

firm has an ethical obligation to the
shareholders to take $243,750 from the
bondholders so that they can give $82,500
to the shareholders?
By the way, the NPV of the project is
–$161,250 = $82,500 – $ 243,750
The Underinvestment Problem

With risky debt outstanding, if stockholders

gain from an increase in the risk of the
firm’s investments, they lose from a
decrease in the risk of the firm’s
investments.
 Value of an option declines as the risk of the
underlying asset decreases.
Thus, stockholders may refuse to invest in a
low-risk but positive NPV investment.
 The Underinvestment Problem
Before Low-Risk Investments After Low-Risk Investments
Total Firm Total Firm
Value NPV > 0 Value
Market

Market Value of
Promised Promised
Payment to Value of Stock Payment to
Debtholders Debtholders
Stock Wealth
Transfer
Market
Market Value
Value of Debt
of Debt
Claim Dilution Problem

Claims of existing debtholders can be

diluted in two ways:
 via dividend policy
 via new debt
Dividend Dilution
In the previous example, what if the board
declared a $450,000 cash dividend today?
 Dividend Dilution
The balance sheet would change from
Assets Liabilities
Cash $450,000 Equity $30,000
Assets $230,000 Debt $650,000
Total $680,000 Total $680,000
To
Assets Liabilities
Cash $0 Equity $0
Assets $230,000 Debt $230,000
Total $230,000 Total $230,000
 A General Formula

Sources ≡ Uses

NOI + New Security Issues ≡ Dividends + Investment

 T   T   T 
D  k   Et     St   F    Dt 
 t 0   t 0   t 0 
Claim Dilution via Dividend
Policy
Paying out cash dividends has two effects:
 It reduces the firm’s cash and its owner’s equity.
 It increases the risk of the remaining assets (since cash
is riskless).
Reduction in owner’s equity enlarges the firm’s
proportion of debt financing.
 This increases the risk of the debt, and decreases its
value.
Increase in the risk of the firm’s assets also
increases stockholder wealth.
Claim Dilution via New Debt

Newly issued debt can reduce the chance that

existing debtholders will be paid the promised
amount.
 This occurs if the new debt’s claims are at least as
senior as the old debt’s claims.
This increased risk of existing debt reduces its
value.
Stockholders get the benefit from this decline in
value.
Consumer-Firm Conflicts

These can be of two types, depending on

who is the agent and who is the principal.
 Guarantees and Service after Sale
 The Free Rider Problem
Guarantees and Service After Sale

The firm is the agent, and the consumer is

the principal.
If the principal does not expect the agent to
fulfill its promise, it will not pay full value
for the firm’s products and services.
The Free Rider Problem

The firm is the principal and the consumer is the

agent.
The agent has the option to duplicate the firm’s
products/services at a lower cost.
Examples include copying of computer software,
books, videotapes etc.
Copyright laws are designed to protect and
encourage the development of valuable ideas.
Practical Contractual
Considerations
Financial Distress
 Financial distress increases the conflicts between the
various stakeholders of the firm.
 Firms in financial distress have a greater incentive to
engage in asset substitutions and underinvestment -
they have little to lose, and a lot to gain.
 Stakeholders may form coalitions to act in their best
interest, even though these actions may conflict with
shareholder interests.
Practical Contractual
Considerations
Financial contracts are complex because
they involve imperfect information.
Agents may send “noisy” signals so as not
to reveal their hand.
Well designed contracts can lead to more
credible signals.
Mitigating Stockholder-Manager
Conflicts
Agents with good reputation can demand higher
prices for their products / services.
Management contracts can include monetary
incentives:
 Stock options
 Performance shares
 Bonuses
Threat of takeovers and replacement can induce
managers to act in shareholder interests.
Mitigating Debtholder-
Stockholder Conflicts
Debtholders may restrict wealth appropriating
behavior on the part of stockholders through debt
contracts.
An indenture is the explicit legal contract for a
publicly traded bond.
The indenture contains covenants:
 Negative covenants restrict certain actions of the firm.
 Positive covenants require certain actions on the part of
the firm.
Mitigating Debtholder-
Stockholder Conflicts
Covenants benefit the bondholders by lowering
the risk of the bonds.
They also benefit the stockholders since the
reduced risk of the bonds implies lower interest
rates.
Covenants can be costly to the stockholders:
 Reduces the firm’s operating flexibility.
 Monitoring costs must be paid to ensure that the
covenants are adhered to.
Mitigating Debtholder-
Stockholder Conflicts
Convertible Bonds
 These can be exchanged for a pre-specified
number of shares of the firm’s common stock,
at the bondholder’s option.
 Bondholders can benefit from the up-side
potential of successful risky investments.
Monitoring Devices

New External Financing

 When a firm seeks new external financing, it is
subject to special scrutiny.
 The willingness of investment bankers to
underwrite the issue acts as a certification
device.
 Firms that frequently raise capital from external
sources are monitored more efficiently.
Monitoring Devices

Other devices include:

 Financial statements and auditor’s reports
 Cash dividends

 Bond ratings

 Government regulation

 Reputation effects

 Multilevel organizations