Agency conflicts

9 important questions on Agency conflicts

What is The Leverage Ratchet Effect

Agency costs of increasing debt fall on existing debtholders
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

highest for long term debt
lowest for short term debt

38

What are debt covenants

Loan conditions placing restrictions on the firm.
+ 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

Using leverage allows the original owners to maintain their equity stake

41

What would motivate managers to undertake negative NPV investments?

Empire building
Overconfidence
Free-cash-flow hypothesis (more cash = more empire building)

48 - 49

Agency costs & tradeoff theory

firms trade off the tax benefits of debt with the agency costs created by that debt

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

Managers minimize leverage to prevent job loss that would accompany financial distress but are constrained from using too little debt (to keep shareholders happy)

59

Relationship equity pricing and capital structure

Managers who believe equity is underpriced will use
retained earnings or
debt

Managers who believe equity is overpriced will
issue equity

82

Explain Pecking Order Hypothesis

Managers' preference to fund investments in this order
  1. retained earnings
  2. debt
  3. equity


83

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