Agency Costs

1.What are agency costs, and how are agency costs of financial distress different from agency benefits of leverage? Explain their impact on calculating the value of a firm with financial distress. Agency costs arise when conflicts of interest occur among stakeholders and must be paid out to an agent acting on behalf of a principal. There is an agency cost that exists in every business that has owners or shareholders and managers who are not necessarily owners. Agency cost means that shareholders and business managers may not necessarily agree on the actions that are best for the business firm and that there is an inherent cost to that disagreement.

That leads to what is called the agency problem. When a firm has leverage, a conflict of interest exists if investment decisions have dissimilar consequences for the value of equity and the value of debt. These conflicts happen when there is a high concern of financial distress and can only arise when there is a chance that the firm will default. For example, if the firm managers’ actions are positive for the shareholders but negative for the firm’s creditors which, in turn, lowers the overall total value of the firm. Shareholders wish for management to run the company in a way that increases shareholder value. On the other hand, management may wish to grow the company in ways that capitalize on their personal power and goals that may not be in the best welfare of shareholders.

Agency costs of financial distress are different from agency benefits of leverage because even though equity holders may benefit at the expense of debt holders’ from these negative NPV actions taken in times of distress, debt holders recognize this move and pay less for the debt when it is first issued, reducing the amount the firm can dole out to shareholders. The net result is a reduction in the initial share price of the firm corresponding to the negative NPV of the actions.

Ultimately, it is the shareholders of the firm who swallow these agency costs. Agency costs represent an additional cost of growing the firm’s leverage that will affect the firm’s optimal capital structure choice. The costs increase with the risk, i.e., the amount of debt held by the firm. Here are some agency costs of leverage: •Excessive risk taking and asset substitution •Debt overhang and under investment •Cashing out Debt maturity and covenants can help to mitigate the agency costs of debt.

The degree of agency costs frequently depends on the maturity of debt. Agency costs are highest for long-term debt and smallest for short-term debt. Debt Covenants are conditions of writing a loan in which creditors place limitations on actions that a firm can take. Covenants may help to reduce agency costs; nonetheless, because covenants hinder management flexibility, they have the possibility to avert investment in positive NPV opportunities and can have costs of their own. 2.When securities are fairly priced, why would the original shareholders of a firm pay the present value of bankruptcy and financial distress costs? In the realm of finance, a security refers to any proof of ownership or debt that has been assigned a value and may be sold (The Street, 2014, 1). For the holder, a security represents an investment as an owner, creditor or rights to ownership on which the person hopes to gain profit, such as stocks, bonds or financial options (The Street, 2014, 1). When a company files for bankruptcy or faces a time of financial distress, every individual with a stake in that respective company – from employees to creditors to stockholders, etc. – is essentially linked to the future of that company in terms of how a bankruptcy proceeding may unravel. As such, individuals who hold securities in certain companies have varying changes of getting repaid. It is in this capacity that original shareholders of a firm may pay the present value of bankruptcy and financial distress costs in order to “curb” the effects that an escalating financial issue may have on individual stakeholders as well as the overarching company. Research has found that a shareholder in a company or firm – especially those who have signed on and been a part of that company since the beginning – hold a priority position in relation to assets of the debtor corporation’s estate and their ability or inability to realize on their interests and securities (Kelch, 1993, 264). Thus, when shareholders have been permitted to retain economic interests in debtor or financially unstable companies, those individuals maintain a respective say in what happens to that company, in other words, acting on good faith (Kelch, 1993, 264). 3.What are the dividend payment process and the open-market repurchase process? In your answer, be sure to explain the effects they have in a perfect world. The dividend payment processes, or dividend payment procedures set a procedure that follows: declaration date; ex-dividend date; holder of record date; and payment date. Declaration date is the announcement that a company’s overseeing board of directors has approved the payment of a dividend. The ex-dividend date is the date is the date upon which investors are “cut off” from receiving a dividend.

For example, if an investor purchases a stock on the ex-dividend date, that investor will not receive the dividend, as this date is two business days before the holder-of-record date (Investopedia, 2014, 1). The ex-dividend date is important as from the day it is issued and forward, new stockholders will not receive a dividend, and as a result, the stock price of a company will be reflective of this. The holder of record date is the date upon which the stockholders who are able to receive the dividend are recognized. Finally, the payment date is the date upon which an actual dividend is paid out to the stockholders on record. The open-market repurchase process, on the other hand, is the reacquisition by a company of its own stock. Open market repurchases are legal transactions to reacquire a company which are generally encouraged by regulators to avoid instances of insider trading or liability. In terms of a repurchase, the open market method is largely considered to be the most common share method in the United States. In cases where this is an option, a firm or company will announce that it will repurchase some shares in the open market from time to time as market conditions dictate. In this capacity, a company or firm holds the upper hand in terms of repurchasing, as it will decide when, where, and how much of a company to repurchase, and this tactic can take upwards of months and years to be completed. 4.What are the benefits and drawbacks of accumulating cash balances rather than paying dividends and what effects do dividend policy have on this type of decision? Today, many companies are accumulating cash balances rather than paying dividends in the wake of an uncertain fiscal and economic future. As dividend policy is largely concerned with financial policies regarding paying cash dividends in the present or paying an increased dividend at a later stage, many companies remain uncertain about their respective statuses at this “later stage” in the game and are choosing to opt out of dividend policy all together. As dividend policy as well as the time and extent of these dividend policies must be chosen by a company’s management team, various factors must be taken into account by these managerial higher-ups in order to impose dividend policy on the entirety of a company, often effecting stocks, shareholders, taxes, and the option to gain or maintain securities.

For many companies, the future is generally unstable and indeterminate, and as such, many companies are choosing a less-risky option, accumulating cash balances. CNBC notes that amid recent lackluster earning seasons, that featured many companies missing sales expectations, cash balances have swelled significantly, and corporations are now stowing away cash at record rates, reluctant to invest in their businesses or hire new workers as uncertainty continues to cloud the future (Cox, 2012, 1). This research, as well as an overarching uncertainty regarding the future of fiscal policy and economics in general in the United States and across much of the western world has found that many people are far less concerned about financial risks and are more concerned about the capacity for growth, both on an individual as well as a corporate level. In a post-recession environment, investors and businesses seem to be on a separate page, but both in understanding as to why certain companies are holding onto cash. For instance, CNBC notes: “There’s this free-floating waiting period . . . waiting for certainty” (Cox, 2012, 1). 5.What impact does asymmetric information have on the optimal level of leverage? In your answer, be sure to describe the implications of adverse selection and the lemons principle for equity issuance, as well as the empirical implications. Asymmetric information is found in a situation in which one party in a transaction has more or superior information as compared to the other party in that transaction. For instance, asymmetric information can occur when a seller knows more than a buyer or vice versa, and such an instance can become harmful due to the fact that one party has the opportunity to take advantage of the other. In this case, the party with the increased level of information essentially has all the leverage in a financial deal, because he or she can take the excess information into account and force the hand of the other member of the transaction, in effect. In this capacity, there comes a chance of adverse selection, in which undesirable results can occur when buyers and sellers possess the aforementioned asymmetric information, and because individuals have access to different information, undesirable products or services are more likely to be selected in the respective transaction. Also into play comes the lemons principle, which says that in the presence of people in a market who are ready to offer bad or inferior goods, these inferior goods tend to wipe a market out of existence if it isn’t empirically possible to distinguish the good products from the bad. As such, if a seller is in a lemons situation, that seller has to send the right signals to the prospective buyers in order to distinguish oneself from others to gain a customer’s confidence in the services and terms of an agreement that is being offered. In this manner, typically, good companies and products are able to distinguish themselves from the bad, empirically paying higher dividends, higher returns, and the like. 6.Compare and contrast mature profitable firms with stable cash flows with firms with higher risk (dependencies on economy) with unstable cash flows. What risks do they take in regards to leverage use, tax shields, and trading information between managers and investors? Mature profitable firms with stable cash flows are far more reliable in terms of fiscal and economic responsibility to shareholders than are higher risk firms with unstable cash flows. In certain situations, these high-risk firms, which are largely dependent upon the economy, have the ability to provide their shareholders with extreme levels of success and wealth, should the economy be in a state of influx and prosperity. In such cases, significant increases in cash flow allow shareholders to believe – albeit irrationally – that these firms are extremely successful and will reap these kinds of benefits for years to come, essentially making their shareholders rich. However, such prosperous situations are not the norm, and occur only in situations of economic prosperity, which sets shareholders up for instances of exceeding loss as well as success, which can leave these shareholders only breaking even or finding themselves at a loss. As such, the more reliable investment appears to be the more reliable and stable companies, which bring in reasonable and steady cash flows over time. Just as a shareholder takes on a risk in becoming involved with these high-velocity companies, so do managers and higher-ups within these firms.

For instance, taxation, trade and everyday business may seem easy enough when a company or firm is experiencing high levels of cash flow and success, but when this success goes away; companies like this are prone to implode upon themselves. As such, these times of uncertainty significantly harm investors, managers, employers and all shareholders, who exist at the mercy of a volatile company. References Cox, J. (2012). “Companies are sitting on more cash than ever before.” CNBC. Web. Retrieved from: https://www.cnbc.com/id/49519419 on 23 May 2014. Investopedia. (2014). “Dividend payment procedures.” Investopedia. Web. Retrieved from: https://digitalcommons.law.umaryland.edu/cgi/viewcontent.cgi?article=2863&context=mlr on 23 May 2014. Kelch, T. (1993). “Shareholder control rights in bankruptcy.” Maryland Law Review, Web. Retrieved from: https://digitalcommons.law.umaryland.edu/cgi/viewcontent .cgi?article=2863&context=mlr on 23 May 2014. The Street. (2014). “Securities Definition.” The Street.

Web. Retrieved from: https://www.thestreet.com/topic/47042/securities.html on 23 May 2014.

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