Chapter 2: Agency costs and the amount of leverageCorporate Finance - MSc in Finance (BGSE)
Albert Banal-Estañol
Universitat Pompeu Fabra and Barcelona GSE
Albert Banal-Estañol (UPF and BGSE) Chapter 2 1 / 36
Corporate Finance - MSc in Finance (BGSE)
In this chapter...
What are �agency costs�?
Con�icts of interest between debt holders & shareholders
Con�icts of interest between managers & shareholders
What is the optimal capital structure?
A model of agency costs (Holmstrom and Tirole, 1979)
Underinvestment (�debt overhang�) model (Myers, 1977)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 2 / 36
Corporate Finance - MSc in Finance (BGSE) What are agency costs?
Agency problems
In an �agency relationship�...
a principal engages an agent to perform a task on his or her behalfinvolves delegating authority by the principal
Examples?
Questions:
Will the agent act in the best interest of the principal?What will the principal need to do? And the agent?
Agency costs: costs of these con�icts of interest
Albert Banal-Estañol (UPF and BGSE) Chapter 2 3 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between debt holders & shareholders
Con�icts of interest between debt holders & shareholders
Managers. . .
often own shares and are elected by shareholdersgenerally maximise shareholder�s wealth, sometimes at the expense ofother investors (debt holders) and even at expense of the �rm�s value
We will now see some examples, e.g....
Over-investment: Shareholders can gain by taking a negative-NPVproject, if su¢ ciently riskyUnder-investment (debt overhang): Shareholders might not invest inpositive NPV projects because value of taking it goes to debtholders
How should one adjust the capital structure?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 4 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between debt holders & shareholders
Over-investment at Baxter, Inc.?
Loan of $1 million due at the end of the year
Without any change,. . .
market value of its assets will be $900,000 at that timeTherefore the �rm will default on its loan and go bankrupt
New strategy is possible:
No up-front investment and 50% chance of successIf strategy is successful, value of the �rm�s assets: $1.3 millionIf not, value of the �rm�s assets: $300,000
Should Baxter adopt the new strategy? According to. . . ?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 5 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between debt holders & shareholders
Under-investment at Baxter, Inc.?
Loan of $1 million due at the end of the year
Without any change,. . .
market value of its assets will be $900,000Therefore the �rm will default on its loan and go bankrupt
New strategy (2):
Initial investment: $100,000 and risk-free 50% returnRisk free-interest rate: 5%
Should Baxter adopt this strategy?
If so, how to pay for it (no cash available)? New equity?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 6 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between debt holders & shareholders
Other agency costs
Cashing out:
incentives to withdraw money just before default (e.g. sell assets belowmarket value and use funds to pay immediate dividend)
Shortsighted investment problem:
tendency to take up projects that pay up early
Reluctance to liquidate problem:
keep �rm operating even if liquidation exceeds operation value
Albert Banal-Estañol (UPF and BGSE) Chapter 2 7 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between debt holders & shareholders
In sum,...
Leverage can encourage insiders to take actions that...
increase shareholders�valuebut reduce debt and �rm�s value
Who bear the costs?
debt holders less willing to pay for new debtless money to distribute to shareholders
This represents another cost of increasing leverage
Solutions:
issue debt with shorter maturity (drawbacks?)�debt covenants�: restrictions on actions (drawbacks?)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 8 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
Con�icts of interest between managers & shareholders
Separation of ownership and control. Managers...
own small participations (median of 0.25% Jensen and Murphy, 1990)are rarely dismissed (Warner et al., JFE 1988)but control the corporation. Why?
Managers care about. . .
Investors (equity and debt holders)Customers and suppliers, employeesThemselves!
Can capital structure help solving the potential interest con�ict?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 9 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
What should the corporate structure be?
An entrepreneur (initial owner) needs funds to expand:
borrow money orissue shares (needs to sell 40% of the shares)
How does each option changes his incentives to...
exert personal e¤ort in running the �rm?enjoy perks (corporate jet, large o¢ ce,...)?
Who pays for these �agency� costs?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 10 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
A simple exampleJensen and Meckling, JFE 1976
Two-period setting (t = 0, 1) and a �rm with
cash �ow x at t = 1equity and debt (B repayment promised at t = 1)
Manager receives compensation only through her fraction 1� α of theequity (α fraction of equity held by outsiders)
Stake Payo¤s at t = 1Debt minfB, xgOutside equity αmaxfx � B, 0gInside equity (1� α)maxfx � B, 0g
Additionally, she can...
take an unobservable action at t = 0 (�e¤ort�, e 2 f0, 1g)if e¤ort exerted (e = 1) payo¤ increased by 1 unit at t = 1but exerting e¤ort has a personal cost
Albert Banal-Estañol (UPF and BGSE) Chapter 2 11 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
Incentives to exert e¤ort in the two polar cases?
Only debt (B > 0, α = 0) Only equity (B = 0, α > 0)
Outsiders2 4
0
5
x2 4
0
5
x
Manager2 4
0
5
x2 4
0
5
x
Albert Banal-Estañol (UPF and BGSE) Chapter 2 12 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
Incentives
Incentives depend on x
Increase in x Incentives with debt Incentives with equity Best?0! 1 None Some Equity1! 2 Some Some Ambiguous2! 3 Full Some Debt
Albert Banal-Estañol (UPF and BGSE) Chapter 2 13 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
Results
Distinction between inside and outside �nancing:
Outside �nance has potential agency costsMaximum inside participation desirable but has limits:
Managerial wealthManagerial risk aversion (no diversi�cation)
Securities used for outside �nance mater:
Capital structure should minimise agency costsDebt is better if bankruptcy not likelyEquity is better if bankruptcy is likely
Rationale for ��nancial restructurings� (equity for debt) in bad times
Albert Banal-Estañol (UPF and BGSE) Chapter 2 14 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
Other con�icts between ownership and control
Investment in negative NPV projects:
Empire building: increase size of the �rmOvercon�dence
Free cash �ow (FCF) hypothesis (Jensen, AER 86):
Wasteful spending more likely if large FCFLeverage...
(i) commits �rm to make interest payments(ii) reduces manager�s ability to misbehave(iii) forces debtholders to monitor moreAs a result, it increases the �rm�s value
Albert Banal-Estañol (UPF and BGSE) Chapter 2 15 / 36
Corporate Finance - MSc in Finance (BGSE) Con�icts of interest between managers & shareholders
Leverage and commitment
Leverage and bankruptcy threat might...
Force them to negotiate more vigourously with unions or suppliers(Perotti and Spier, AER 1993)Force them to compete more aggressively in the product market(Brander and Lewis, AER 1986)
They represent other bene�ts from leverage
Albert Banal-Estañol (UPF and BGSE) Chapter 2 16 / 36
Corporate Finance - MSc in Finance (BGSE) What is the optimal capital structure?
Summarising Agency Con�icts
Con�ict of interest between shareholders and debtholders:
Managers maximise shareholder�s wealth, sometimes at the expense ofdebt holders and even at expense of �rm�s valueThis tends to be the case when the �rm is close to bankruptcyFirm can reduce the possibility of bankruptcy reducing the leverage
Con�ict of interest between managers and shareholders:
Managers also care about customers, ... and themselves!Higher equity stake encourages them to increase �rm�s valueExternal �nancing in debt gives more incentives than in equity (innormal times)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 17 / 36
Corporate Finance - MSc in Finance (BGSE) What is the optimal capital structure?
Leverage with Taxes, Financial Distress, & Agency Costs
Albert Banal-Estañol (UPF and BGSE) Chapter 2 18 / 36
Corporate Finance - MSc in Finance (BGSE) What is the optimal capital structure?
The Optimal Debt Level
R&D-intensive �rms
High R&D costs and future growth opportunities, low debt levelsLow current free cash �ows and risky business strategies
Low-growth, mature �rms:
Stable cash �ows and tangible assets often carry high-debtHigh free cash �ows with few good investment opportunities
Albert Banal-Estañol (UPF and BGSE) Chapter 2 19 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
A model of agency con�ictsHolmstrom and Tirole, 1979
Formalise con�icts between managers and investors
Setup:
�Entrepreneur�needs external �nancing for a projectInvestors are competitive (many investors)Con�ict of interest between entrepreneur and investorsAsymmetric information leads to �moral hazard�
Questions:
What is the �optimal contract�?Does it resemble debt or equity?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 20 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
A Simple Model
Entrepreneur has a project that requires investment I but her assetsare only worth A < I (needs to borrow I � A)Project may be successful (probability p) and yield R > 0or fail (probability 1� p) and yield 0Entrepreneur may exert e¤ort (p = pH ) or shirk (p = pL), with∆p = pH � pL > 0If she shirks she obtains private bene�ts B > 0
Moreover,...
Entrepreneur has limited liability (no punishment for failure)Investors are competitive (many, make zero pro�t)Both entrepreneur and potential investors are risk neutralThere is no discounting
Albert Banal-Estañol (UPF and BGSE) Chapter 2 21 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Optimal Contract
Optimal contract speci�es how pro�t shared:
Both should get 0 in case of failure (limited liability)In case of success, de�ne sharing rule as Rb + Rl = R
Competitive lending implies (assuming e¤ort exerted): pHRl = I � AInvestors�return is given by...
(1+ i)(I � A) = Rl or 1+ i = 1/pHHence, unless pH = 1, we have i > 0 (default premium)
Assume:
(a) project has positive NPV if e¤ort exerted, pHR � I > 0(b) negative NPV if not, pLR � I + B < 0 (even adding B)Rewriting, pLRl � (I � A) + pLRb + B � A < 0 (e¤ort necessary)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 22 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Summary: Timing
1 Agreement (sharing rule in the case of success)2 Investment3 Moral hazard (e¤ort or shirk?, unobservable)4 Outcome and payments
Albert Banal-Estañol (UPF and BGSE) Chapter 2 23 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Credit Analysis
Need to ensure that entrepreneur exerts e¤ort
Trade-o¤: private bene�ts vs. higher probability of success
Incentive compatibility constraint:
pHRb � pLRb + B
or
Rb �B∆p
This is the minimum entrepreneur must keep (rent)
Maximum that can be pledged (promised to investors) is
R � Rb = R �B∆p
Albert Banal-Estañol (UPF and BGSE) Chapter 2 24 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Since this is paid only in the case of success, she is �nanced only if
pH
�R � B
∆p
�� I � A
or
A � I � pH�R � B
∆p
�= pH
B∆p� (pHR � I ) � A
To make things interesting assume that A > 0 or
pHB∆p
> pHR � I
i.e. the NPV is smaller than the necessary rent
Thus �nancing is possible only when A � A, even if, when A < A, theproject also has positive NPV
Albert Banal-Estañol (UPF and BGSE) Chapter 2 25 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Lenders may not grant a loan even if entrepreneur is willing to give ahigh fraction of the return
The entrepreneur needs to have enough assets to be �nanced (A � A)In this case, entrepreneur�s stake is given by
R � Rl = R �I � ApH
� R � I � ApH
=B∆p
Entrepreneur�s net payo¤ (subtracting A) is given by�0 if A < ApHRb � A = pH (R � Rl )� A = pHR � I if A � A
She receives entire surplus if project funded (lender breaks even)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 26 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Debt or equity?
Optimal contract was a pro�t sharing agreement
In this simple binary example, this can be thought as a �debt�contract:
Borrow I � A in exchange of a repayment of RlIn case of success, borrower keeps Rb = R � RlIn case of failure, borrower (and lender) get 0
...or as an equity contract:
Entrepreneur�s share α = Rb/R and investors�1� α = Rl/R
Albert Banal-Estañol (UPF and BGSE) Chapter 2 27 / 36
Corporate Finance - MSc in Finance (BGSE) A model of agency costs
Conclusions
In summary,
Because of moral hazard there is a limit to pledgeable incomeProjects with positive NPV may not be fundedThe entrepreneur needs to have enough assets to be �nancedHigher private bene�ts, higher threshold for �nancing
This model can also explain the �credit rationing�puzzle:
Lenders are not willing to raise interest rates even if the demand forloans exceeds their supply at the prevailing ratesLoan markets are personalised
Explanation:
Higher interest rates reduces the stake of the entrepreneurReduced stake may demotivate the entrepreneur and may lower theprobability of repayment (moral hazard)Alternative: If lenders cannot distinguish good from bad borrowers,higher interest rates may attract worse borrowers (adverse selection)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 28 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Remember Baxter?
Loan of $1 million due at the end of the year
Without any change,. . .
market value of its assets will be $900,000Therefore the �rm will default on its loan and go bankrupt
New strategy (2):
Initial investment: $100,000 and risk-free 50% returnRisk free-interest rate: 5%
Should Baxter adopt this strategy?
If so, how to pay for it (no cash available)? New equity?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 29 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Debt Overhang ProblemMyers, 1977
Borrower debt-ridden and unable to raise funds for an otherwisepro�table project
Here we will formalise the idea using the previous framework
Previous investors�collateral claim on �rm�s assets reduces the networth: project produces too little pledgeable income and soinvestment does not take place
Are investors willing to renegotiate?
Albert Banal-Estañol (UPF and BGSE) Chapter 2 30 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Reduce of Net Worth
Same project (NPV>0)Agent has again A but now owes D such that A > A > A�D � 0i.e. without D agent could get �nanced but she�s denied �cause of DMore precisely, pledgeable income net of investment cost is
pH
�R � B
∆p
�� I
Initial investors need at least D (will get this if project is not �nanced)Therefore new investors will get at most,
pH
�R � B
∆p
�� I �D + A = �A�D + A < 0
New investors lose money and thus are not willing to fund
Initial investors would also prefer to obtain D rather than fund it
Albert Banal-Estañol (UPF and BGSE) Chapter 2 31 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Lack of Renegotiation
Model as before but assume that:(i) A < 0 and therefore the project can be �nanced even if A = 0(ii) Debt obligation is senior (serviced �rst)(iii) A = 0 (thus cannot repay D)(iv) A+ pHD > 0
Albert Banal-Estañol (UPF and BGSE) Chapter 2 32 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Initial Investors
Initial investors are willing to participate as long as they break even(get 0 otherwise)
For example if they forgive initial debt and demand all the cash-�owrights in the case of success they obtain
pH
�R � B
∆p
�� I = �A > 0
Borrower also accepts because she obtains pH B∆p rather than 0 (if the
project is not funded)
Albert Banal-Estañol (UPF and BGSE) Chapter 2 33 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
New Investors
What if initial investors do not have more cash? Are new investorswilling to fund?
Given that initial debt is senior and a minimum rent needs to be leftto borrowers, the maximum pledgeable income is
R � B∆p�D
They will provide funding if only if
pH
�R � B
∆p�D
�� I or A+ pHD � 0
contradicting (iv)
Thus, agent cannot raise �nance if there is no renegotiation withinitial investors
Albert Banal-Estañol (UPF and BGSE) Chapter 2 34 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Renegotiation
Suppose that initial investors accept d < D where A+ pHd = 0
New investors receive R � B∆p � d in the case of success and will
�nance since
pH
�R � B
∆p� d
�= I
Agent receives agency rent
pHB∆p
And initial investors receive
pHd = �A > 0
Thus renegotiation makes everyone better o¤
Albert Banal-Estañol (UPF and BGSE) Chapter 2 35 / 36
Corporate Finance - MSc in Finance (BGSE) Underinvestment �debt overhang�
Summary and Conclusions
Previous debt makes it more di¢ cult to obtain funding
Previous debt reduces an entrepreneur�s net worth
Successful renegotiation of debt obligations is key
Debt forgiveness can vary from D � d to D, depending on relativebargaining power
Albert Banal-Estañol (UPF and BGSE) Chapter 2 36 / 36
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