Agency conflicts
9 important questions on Agency conflicts
What is The Leverage Ratchet Effect
so when a firm has existing debt, debt overhang leads to leverage ratchet effect
- shareholders have incentive to INCREASE leverage, even if it decreases firm value
- shareholders will not have incentive to incentive to DECREASE leverage by buying back debt
1 = incentive to INCREASE debt
2 = NO incentive to DECREASE debt
regardless of firm value
34
Relationship debt maturity and agency costs
lowest for short term debt
38
What are debt covenants
+ Covenants reduce agency costs
- Covenants hinder management flexibility
- Potentially prevent positive NPV investments
eg
limiting large dividend payout
restricting certain investment types
39
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Relationship concentration of ownership & control
41
What would motivate managers to undertake negative NPV investments?
Overconfidence
Free-cash-flow hypothesis (more cash = more empire building)
48 - 49
Agency costs & tradeoff theory
thus, they strive towards an optimal leverage (debt) level
They tend to trade off the tax advantage of using debt with the agency cost and bankruptcy cost that may arise due to the use of debt in their capital structure.
54
Management entrenchment and debt level
59
Relationship equity pricing and capital structure
retained earnings or
debt
Managers who believe equity is overpriced will
issue equity
82
Explain Pecking Order Hypothesis
- retained earnings
- debt
- equity
83
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