Chapter 4 Agency Problems in Corporate Finance 4.1 Introduction the standard theory of co.apters 1 and 2 when we covered Modigliani-Miller As we discussed in the Ch apital structure that has been the mainstay of text- books is the trade-off theory This argues that the benefit of debt is the tax shield and the cost is the deadweight costs of bankruptcy. The tradi tional view was that these deadweight costs were bankruptcy and liquidation costs. In the 1970,s this theory was criticized because it didnt seem it could satisfactorily explain observed capital structures. For long periods of time corporations in the US have on average had long term debt worth about 30-40% of their total value(see, e.g., Rajan and Zingales(1995). They have also paid corporate taxes most of the time. Evidence on bankruptcy costs provided by Warner(1977) and others suggested that the direct costs of bankruptcy such as lawyers'fees were low. Haugen and Senbet(1978) pointed out that bankruptcy and liquidation costs should not be confused If liquidation costs were high they could be avoided by renegotiation with debtholders in bankruptcy. Given bankruptcy costs are low and corporate tax rates in the US at that time were 46% the standard theory seemed to suggest that if corporations increased their debt slightly they could increase their value. The fact that they did not do this suggested that the theory was incorrect. The difficulty in explaining firms'payout policy in the Modigliani- Miller framework extended to include taxes(the so-called"dividend puzzle")
Chapter 4 Agency Problems in Corporate Finance 4.1 Introduction As we discussed in the Chapters 1 and 2 when we covered Modigliani-Miller the standard theory of capital structure that has been the mainstay of textbooks is the trade-off theory. This argues that the benefit of debt is the tax shield and the cost is the deadweight costs of bankruptcy. The traditional view was that these deadweight costs were bankruptcy and liquidation costs. In the 1970’s this theory was criticized because it didn’t seem it could satisfactorily explain observed capital structures. For long periods of time corporations in the US have on average had long term debt worth about 30-40% of their total value (see, e.g., Rajan and Zingales (1995)). They have also paid corporate taxes most of the time. Evidence on bankruptcy costs provided by Warner (1977) and others suggested that the direct costs of bankruptcy such as lawyers’ fees were low. Haugen and Senbet (1978) pointed out that bankruptcy and liquidation costs should not be confused. If liquidation costs were high they could be avoided by renegotiation with debtholders in bankruptcy. Given bankruptcy costs are low and corporate tax rates in the US at that time were 46% the standard theory seemed to suggest that if corporations increased their debt slightly they could increase their value. The fact that they did not do this suggested that the theory was incorrect. The difficulty in explaining firms’ payout policy in the ModiglianiMiller framework extended to include taxes (the so-called ”dividend puzzle”) 1
2 CHAPTER 4. AGENCY PROBLEMS IN CORPORATE FINANCE also contributed to the dissatisfaction with traditional approach. All of this lead to a number of other approaches. These included personal taxes(Miller (1977)), and approaches based on asymmetric information. There were two main strands based on asymmetric information, signalling models and agency theory. We will consider the role of signalling in a subsequent chapter. Here we will focus on agency theor In a seminal paper Jensen and Meckling(1976) suggested that we should think of the firm as consisting of groups of securityholders with differing interests rather than as a single agent as traditional theory had done. They emphasized two conflicts. The first is between shareholders or entrepreneurs and bondholders. The second is between shareholders and managers These conflicts lead to two agency problems To illustrate the first agency problem consider the shareholder-bondholder conflict. Given that shareholders obtain any payoff in excess of the debt repayment they (or managers acting in their interest) have an incentive te take risks so that the average payment they receive is increased. They showed that firms acting in the interest of shareholders may be willing to accept negative net present value projects if the shareholders' average payment is increased at the expense of the bondholders. This is the risk shifting(also sometimes called asset substitution) problem. The problem is not restricted to the shareholder-bondholder confict. It can also arise in the context of the shareholder-manager problem The second agency problem that Jensen and Meckling(1976) stressed was the effort problem. This can be illustrated in the context of the between shareholder-manager problem but also arises in the bondholder-entrepreneur problem. If managers have a disutility of effort and are paid a wage then they will have an incentive to shirk rather than act in shareholders'interests It is therefore important that managers' incentives are aligned with those of shareholders Myers(1977)pointed to another crucial agency problem, debt overhang If a firm has a large amount of debt outstanding then the proceeds to any new safe project that it undertakes will How to the existing bondholders. As a result if the firm acts in the interests of shareholders it will be unwilling to accept even safe projects even if they have a positive net present value The papers by Jensen and Meckling(1976) and Myers(1977) had a hu impact. At one point the Jensen and Meckling paper was the most cited paper in Economics. A large literature focused on the conflict between share- holders and managers. Grossman and Hart(1982) pointed to the incentive
2 CHAPTER 4. AGENCY PROBLEMS IN CORPORATE FINANCE also contributed to the dissatisfaction with traditional approach. All of this lead to a number of other approaches. These included personal taxes (Miller (1977)), and approaches based on asymmetric information. There were two main strands based on asymmetric information, signalling models and agency theory. We will consider the role of signalling in a subsequent chapter. Here we will focus on agency theory. In a seminal paper Jensen and Meckling (1976) suggested that we should think of the firm as consisting of groups of securityholders with differing interests rather than as a single agent as traditional theory had done. They emphasized two conflicts. The first is between shareholders or entrepreneurs and bondholders. The second is between shareholders and managers. These conflicts lead to two agency problems. To illustrate the first agency problem consider the shareholder-bondholder conflict. Given that shareholders obtain any payoff in excess of the debt repayment they (or managers acting in their interest) have an incentive to take risks so that the average payment they receive is increased. They showed that firms acting in the interest of shareholders may be willing to accept negative net present value projects if the shareholders’ average payment is increased at the expense of the bondholders. This is the risk shifting (also sometimes called asset substitution) problem. The problem is not restricted to the shareholder-bondholder conflict. It can also arise in the context of the shareholder-manager problem. The second agency problem that Jensen and Meckling (1976) stressed was the effort problem. This can be illustrated in the context of the between shareholder-manager problem but also arises in the bondholder-entrepreneur problem. If managers have a disutility of effort and are paid a wage then they will have an incentive to shirk rather than act in shareholders’ interests. It is therefore important that managers’ incentives are aligned with those of shareholders. Myers (1977) pointed to another crucial agency problem, debt overhang. If a firm has a large amount of debt outstanding then the proceeds to any new safe project that it undertakes will flow to the existing bondholders. As a result if the firm acts in the interests of shareholders it will be unwilling to accept even safe projects even if they have a positive net present value. The papers by Jensen and Meckling (1976) and Myers (1977) had a huge impact. At one point the Jensen and Meckling paper was the most cited paper in Economics. A large literature focused on the conflict between shareholders and managers. Grossman and Hart (1982) pointed to the incentive
4.2. THE RISK SHIFTING PROBLEM effects of debt. If a firm takes on a lot of debt the managers will be forced to work hard. Jensen(1986) also emphasized the incentive aspects of debt in his famous"free cash Hlow "theory. If managers have access to large amounts of funds, i.e. free cash How, they may use it to pursue their own interests rather than the shareholders. One way the shareholders can prevent this is for the firm to take on a lot of debt. Easterbrook(1984)pointed to the incentive effects of dividends. If managers pay out a large amount in dividends they will be unable to waste the funds pursuing their own interests The jensen and Meckling article also lead to a consideration of how the nanagers' incentives could be aligned with those of the shareholders through executive compensation. There is a large literature on executive compensa- tion which is summarized in Murphy(1998 Finally, there is also a large literature justifying debt as an optimal con- tract which uses an agency approach. The three pioneering papers in this lit- erature are Townsend(1979), Diamond(1984)and Gale and Hellwig(1985) In this chapter we will cover the following applications of agency the to corporate finance The risk shifting problem · Debt overhang Debt and equity as incentive devices Executive compensation Debt as an optimal contract 4.2 The Risk Shifting Problem As discussed in the Introduction one of the most important conflicts of inter- est between equityholders and bondholders is that if managers act in equity holders' interest they may accept negative NPV investments at the expense of bondholders The basic idea is the following. Suppose a firm has $1,000 in cash the day before its debt, which has a face value of $5,000, comes due. If the equityholders(or the managers acting on their behalf) do nothing then the firm will go bankrupt and they will get nothing. What should they do? Suppose the equityholders took the cash and went to Atlantic City. If they
4.2. THE RISK SHIFTING PROBLEM 3 effects of debt. If a firm takes on a lot of debt the managers will be forced to work hard. Jensen (1986) also emphasized the incentive aspects of debt in his famous “free cash flow” theory. If managers have access to large amounts of funds, i.e. free cash flow, they may use it to pursue their own interests rather than the shareholders’. One way the shareholders can prevent this is for the firm to take on a lot of debt. Easterbrook (1984) pointed to the incentive effects of dividends. If managers pay out a large amount in dividends they will be unable to waste the funds pursuing their own interests. The Jensen and Meckling article also lead to a consideration of how the managers’ incentives could be aligned with those of the shareholders through executive compensation. There is a large literature on executive compensation which is summarized in Murphy (1998). Finally, there is also a large literature justifying debt as an optimal contract which uses an agency approach. The three pioneering papers in this literature are Townsend (1979), Diamond (1984) and Gale and Hellwig (1985). In this chapter we will cover the following applications of agency theory to corporate finance. • The risk shifting problem. • Debt overhang. • Debt and equity as incentive devices. • Executive compensation. • Debt as an optimal contract. 4.2 The Risk Shifting Problem As discussed in the Introduction one of the most important conflicts of interest between equityholders and bondholders is that if managers act in equityholders’ interest they may accept negative NPV investments at the expense of bondholders. The basic idea is the following. Suppose a firm has $1,000 in cash the day before its debt, which has a face value of $5,000, comes due. If the equityholders (or the managers acting on their behalf) do nothing then the firm will go bankrupt and they will get nothing. What should they do? Suppose the equityholders took the cash and went to Atlantic City. If they
CHAPTER 4. AGENCY PROBLEMS IN CORPORATE FINANCE win they might get $20,000 say. In that case they can pay off the S5, 000 debt and still have $15,000 left over. If they lose they get nothing but they would have got nothing anyway so they are no worse off from gambling. The bondholders are of course worse off if they lose, they get nothing whereas they would have got $1, 000 if the equityholders hadn't gambled. The problem is that when the firm is near bankruptcy the equityholders are gambling with the bondholders money. They will therefore be prepared to invest in risk projects even though they are negative NPV. Although this example may seem rather extreme something rather like it happened early on in Federal Express's history. Fortunately in that case the managers won but they could have easily lost Let us go through this example in a little more detail before we develop a formal model 4.2.1 A Simple Example of Risk Shifting Firm has $1,000 in cash. It has bonds outstanding on which the next payment isS5.000 Firm does nothing Value of bonds s1. 000 Value of equity 0 Firm invests in project costing $1000(payoffs occur immediately so ignore Probability =0.02 Payoff= 20,000 Probability=0.98 Payoff= 0 Expected payoff=-1.000+0.02x20.000=-1,000+400=-600 This is a very bad project Firm does project If it's successful Value of bonds 5.000 Value of equity 15,000 If it's Value of bonds =0 Value of equity =0 Therefore Expected value of bonds = 0.02 x 5,000= 100
4 CHAPTER 4. AGENCY PROBLEMS IN CORPORATE FINANCE win they might get $20,000 say. In that case they can pay off the $5,000 debt and still have $15,000 left over. If they lose they get nothing but they would have got nothing anyway so they are no worse off from gambling. The bondholders are of course worse off if they lose, they get nothing whereas they would have got $1,000 if the equityholders hadn’t gambled. The problem is that when the firm is near bankruptcy the equityholders are gambling with the bondholders money. They will therefore be prepared to invest in risky projects even though they are negative NPV. Although this example may seem rather extreme something rather like it happened early on in Federal Express’s history. Fortunately in that case the managers won but they could have easily lost. Let us go through this example in a little more detail before we develop a formal model. 4.2.1 A Simple Example of Risk Shifting Firm has $1,000 in cash. It has bonds outstanding on which the next payment is $5,000. Firm does nothing: Value of bonds $1,000 Value of equity 0 Firm invests in project costing $1000 (payoffs occur immediately so ignore discounting): Probability = 0.02 Payoff = 20,000 Probability = 0.98 Payoff = 0 Expected payoff = -1,000 + 0.02x20,000 = -1,000 + 400 = -600 This is a very bad project. Firm does project: If it’s successful, Value of bonds = 5,000 Value of equity = 15,000 If it’s unsuccessful, Value of bonds = 0 Value of equity = 0 Therefore, Expected value of bonds = 0.02 x 5,000 = 100
4.2. THE RISK SHIFTING PROBLEM Expected Value of equity =0.02 x 15,000= 300 otice that the bondholders are worse off by 900 and the equityholders are better off by 300. The NPV of the project was -600 so this is the majority of the drop in value with the other 300 coming from the transfer to equity. Thus even though its a lousy project, it's worth doing as far as the equityholders are concerned. The conclusion is that the stockholders of levered firms gain when business risk increases and this leads to an incentive to take risk 4.2.2 A Formal Model of Risk Shifting Let a denote the set of actions available to the manager with generic element a. Typically, A is either a finite set or an interval of real numbers. Let s denote a set of states with generic element s. For simplicity, we assume that the set S is finite. The probability of the state s conditional on the action a is denoted by p(a, s). The revenue in state s is denoted by R(s)20 The manager's utility depends on both the action chosen and the con- sumption he derives from his share of the revenue. The shareholder's utility depends only on his consumption. We maintain the following assumptions about preferences · The agent' s utility function u:A×R+→ R is additively separable (a,c)=U(c)-v(a) Further, the function U: R+- R is C and satisfies U(c>0 and U"(c)≤0. The principal's utility function V: R-R is C and satisfies V(c>0 nd"(c)≤0 Notice that the manager's consumption is assumed to be non-negative This is interpreted as a liquidity constraint or limited liability. Pcr Risk shifting iects, other things being equal. We can think of this as a ccurs when the manager has a convex reward schedule and fers riskier proj case where the principal is a bondholder and the agent is the managers of the firm acting in the shareholders'interest who have issued debt to finance the risky venture
4.2. THE RISK SHIFTING PROBLEM 5 Expected Value of equity = 0.02 x 15,000 = 300 Notice that the bondholders are worse off by 900 and the equityholders are better off by 300. The NPV of the project was -600 so this is the majority of the drop in value with the other 300 coming from the transfer to equity. Thus even though its a lousy project, it’s worth doing as far as the equityholders are concerned. The conclusion is that the stockholders of levered firms gain when business risk increases and this leads to an incentive to take risks. 4.2.2 A Formal Model of Risk Shifting Let A denote the set of actions available to the manager with generic element a. Typically, A is either a finite set or an interval of real numbers. Let S denote a set of states with generic element s. For simplicity, we assume that the set S is finite. The probability of the state s conditional on the action a is denoted by p(a, s). The revenue in state s is denoted by R(s) ≥ 0. The manager’s utility depends on both the action chosen and the consumption he derives from his share of the revenue. The shareholder’s utility depends only on his consumption. We maintain the following assumptions about preferences: • The agent’s utility function u : A × R+ → R is additively separable: u(a, c) = U(c) − ψ(a). Further, the function U : R+ → R is C2 and satisfies U0 (c) > 0 and U00(c) ≤ 0. • The principal’s utility function V : R → R is C2 and satisfies V 0 (c) > 0 and V 00(c) ≤ 0. Notice that the manager’s consumption is assumed to be non-negative. This is interpreted as a liquidity constraint or limited liability. Risk shifting occurs when the manager has a convex reward schedule and prefers riskier projects, other things being equal. We can think of this as a case where the principal is a bondholder and the agent is the managers of the firm acting in the shareholders’ interest who have issued debt to finance the risky venture