F402 Corporate Financial

Strategy and Governance

Class 28: Agency Cost and Information
Asymmetry (I)

Dr. Xuan Tian

Indiana University
December 2, 2010
Where are we now?
• (√) Review of financial, statistic, and economic tools
• (√) Security valuations and risk evaluation
• ( ) Real corporate finance problems
 (√) Which technique should I use to evaluate projects?
--Capital Budgeting
▫ (√) How do I raise money?
▫ (√ ) How much debt should I have on my balance sheet?
▫ (√ ) What should I do with “extra” cash?
▫ (√ ) How do I evaluate and execute mergers and
acquisitions?
▫ ( ) How to mitigate information gap and align the interests
of shareholders and financial managers?
▫ ( ) What is venture capital and private equity market?
Two types of conflicts of interests
(agency problems)
• Shareholders Vs. Managers
▫ Costs arise from the fact that corporate managers
(CEOs, for example) may maximize their own
value (utility/satisfaction) at the expense of the
shareholders.
• Bondholders Vs. Shareholders
▫ Risk shifting
▫ Underinvestment
▫ Milking the property
Shareholders Vs. CEOs
• CEOs are “agents” of firm shareholders, but their
interests may not be fully aligned with
shareholder (principal) interests.

• Agency problem arises when CEO has less than

100% of equity.
An example
• Assume a CEO can “steal” resources (or engage
in negative NPV activities that please him). If the
CEO has 100% equity in firm, he has no
incentives to steal.
▫ For every $1 he steals, share value drops by $1,
and he bears full cost of his activity.
• What about if he only owns 80% of the firm?
▫ He has incentives to steal, because he only bears
partial cost of his activity but enjoys the whole
benefit from stealing.
An example (cont’d)
• We denote the firm value by V
▫ If the CEO does not steal, his utility is 0.8V;
▫ If the CEO does steal, his utility is
0.8(V-$1)+$1=0.8V+0.2
▫ As a rational human, why not steal?
• Lower the fraction of equity in the firm held by
CEO, more the amount stolen in equilibrium.
• In an extreme situation (CEO has zero
ownership), he bears no cost at all but enjoys the
whole benefit from stealing.
Are shareholders fools?
• Shareholders will anticipate such behavior if
they are rational.
• Therefore, if a CEO, who owned 100% equity to
begin with, starts divesting, the valuation placed
by outsiders on each 1% of equity he sells will be
smaller as his equity-holding in the firm gets
smaller.
• In other words, it is ultimately the CEO himself
who bears this agency cost of equity.
What CEOs could do to limit the costs
• CEOs have incentives to limit the “stealing”
activities but it is not easy.
▫ Stealing is not observable and contractible
▫ A “promise” not to steal at the time of selling
equity to outsiders is not credible (will be reneged
upon later, shareholders know!)
Mechanisms to reduce agency costs
• Monitoring, by
▫ Board of directors (independent directors)
▫ Large shareholders/institutional investors
 Banks, insurance companies, mutual funds, pension
funds, private trust, and endowments
 They hold almost 50% of equity claims of corporations.
• Optimal executive compensation packages that link
a large chunk of pay to stock price performance
▫ Stock options
▫ Performance-based bonus
▫ High salary
Debt as a way to mitigate agency
problem (Jensen 1986, free cash flow
theory)
• Free cash flow: cash flow in excess of that
required to fund all positive NPV projects.
• Key idea: by issuing debt, managers are
effectively committing to pay out future free cash
flows.
• Dividend increases have the same
“commitment” effect but weaker: debt holders
can take the firm to bankruptcy court if they
renege!
▫ Leveraged buyouts (LBOs) is an example of the
benefits of reducing agency costs using debt.
An example
• Firm A is an all equity firm
• Firm B is highly leveraged with senior debt,
convertible debt, and common equity.
• If management invests in value-reducing projects
and the firm defaults on some interest payments,
firm B shareholders as well as bondholders can step
in.
• Firm A shareholders can do nothing if the same
situation happens and the firm reduces (or omits)
the dividends.
Shareholders Vs. Bondholders (Agency
cost of debt)
• Agency costs arise from conflicts of interest
between stockholders (as a group) and
bondholders (as a group).
▫ Stockholders have an incentive to increase share
value at the expense of the value of bonds (debt)
• Most severe in firms with a high chance of
bankruptcy
• Empirical evidence shows that such costs are
much higher than direct/indirect costs of
bankruptcy (lawyer fees, loss of business, etc)
• Assume the firm has a $30M debt outstanding and a cash of $35M available for investment
. For simplicity, interest rate is zero. And if firm default, it cant use its extra cash to pay
bondholders because of some covenants implemented
Project S (Safe) Project R (Risky)
Boom Prob=.5 40M 58M
Recession Prob=.5 20M 0
Investment 25M 30M

▫ Which project should be implemented?

 NPVs =.5*40 +.5*20 -25 =5 -> choose
 NPVr =.5*58 +0 -30 = -1
▫ Which project will shareholders implement? Why?
 Shareholder’s value S =.5(40-30) +. 5*0 +35 -25 =15
 Shareholder’s value R =.5(58-30) + .5*0 +35 -30 = 19 -> choose
▫ What is the value of debt with project S and project R, respectively?
 Value of debt S =.5*20 +.5 *30 = 25 -> choose
 Value of debt R =.5* 30 +.5 *0 =15
▫ What will the debt sell for? .5F +.5*0 =30 -> F= 60 (r=100% >stated r =0%)
Mechanisms for controlling agency cost
of debt
• Debt covenants
▫ Controls what shareholders can and cannot do
 For example, dividends cannot be paid till debt payments outstanding.
▫ Concept check: Who ultimately benefit from having debt covenants?
• Convertible Bonds
▫ Convertible bonds reduce agency costs by aligning the incentives of stockholders
and bondholders.
▫ It allows bondholders to share in the “upside” if shareholders choose risky project,
which mitigate the risk shifting problem.
An Introduction to Convertible Bond
• Debt with conversion feature (to equity), i.e., it gives
the holder the right to exchange it for a given
number of shares of stock anytime up to and
including the maturity date of the bond.
• Example: a convertible bond with face value of
$1000. It is convertible to equity at $20 per share
(conversion price).
• Conversion ratio is the number of shares each bond is
entitled to , which is 50 shares/bond in this case.
An (big) example
• Assume the firm has a $30M debt outstanding
and a cash of $35M available for investment. For
simplicity, interest rate is zero.
Project S (Safe) Project R (Risky)
Boom Prob=.5 40M 58M
Recession Prob=.5 20M 0
Investment 25M 30M

▫ Which project should be implemented?

▫ Which project will shareholders implement? Why?
▫ What is the value of debt with project S and project R,
respectively?
▫ What will the debt sell for?
• How can we cope with this problem?
▫ Bond covenants (not always useful)
▫ Issue convertible bonds
• Solving the problem using convertible debt.
▫ Choose α of the convertible debt issue such that shareholders are induced to
pick project S rather than project R,
 i.e., choose α so that bondholders will convert to equity if project R is
chosen and successful.
▫ Expected cash flow to shareholders from choosing project R has to be ≤
expected cash flow to equity from choosing project S (we need to pick α to
ensure this).
• Project R: bondholders convert to equity and shareholders’ payoffs
= .5*(1- α)*58+.5*0+35-30
• Project S: bondholders do not convert and shareholders’ payoffs
= .5*(40-30)+.5*0+35-25
• What we need
= .5*(1- α)*58+.5*0+35-30≤.5*(40-30)+.5*0+35-25  α≥0.655
An (big) example (cont’d)
• For example, α=0.66 is chosen. What is the optimal conversion policy for
convertible bond holders?
Project Outcome Cash flow Action
Project R is chosen Successful 0.66*58=38.28>30 Convert
Unsuccessful 0=0 Not Convert
Project S is chosen Successful 0.66*40=26.4<30 Not Convert
Unsuccessful 0.66*20=13.2<20 Not Convert

• Expected cash flow to shareholders

▫ 0.5*(1-0.66)*58+0+35-30=14.86M if R is chosen
▫ 0.5*(40-30)+0.5*0+35-25=15M if S is chosen
• Equity holders will choose project S and the agency problem is solved!
Empirical evidence: when are
convertibles used?
• Convertibles are used for firms with
▫ High growth rates (more risky projects available)
▫ High leverage (risk shifting problem is more
severe)
▫ Lower credit ratings (risk-shifting problem is
more severe)
Key Points
• Agency problem arises from the conflict of
interests
▫ Shareholders Vs. Managers
▫ Bondholders Vs. Shareholders
• It is “the agent” who bears such agency costs.
▫ Mangers (shareholders Vs. managers)
▫ Shareholders (bondholders Vs. shareholders)
• It is “the agent” who benefits from any
mechanism that can effectively mitigate agency
problems!