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Corporate Finance

Corporate Finance. Class 13 Agency Costs and Information Asymmetry Daniel Sungyeon Kim Peking University HSBC Business School. Two types of conflicts of interests (agency problems) . Shareholders Vs. Managers

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Corporate Finance

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  1. Corporate Finance Class 13 Agency Costs and Information Asymmetry Daniel Sungyeon Kim Peking University HSBC Business School

  2. Two types of conflicts of interests (agency problems) • Shareholders Vs. Managers • Costs arise from the fact that corporate managers (CEOs, for example) may maximize their own value (utility/satisfaction) at the expense of the shareholders. • Bondholders Vs. Shareholders • Risk shifting • Underinvestment • Milking the property

  3. Shareholders Vs. CEOs • CEOs are “agents” of firm shareholders, but their interests may not be fully aligned with shareholder (principal) interests. • Agency problem arises when CEO has less than 100% of equity.

  4. An example • Assume a CEO can “steal” resources (or engage in negative NPV activities that please him). If the CEO has 100% equity in firm, he has no incentives to steal. • For every $1 he steals, share value drops by $1, and he bears full cost of his activity. • What about if he only owns 80% of the firm? • He has incentives to steal, because he only bears partial cost of his activity but enjoys the whole benefit from stealing.

  5. An example (cont’d) • We denote the firm value by V • If the CEO does not steal, his utility is 0.8V; • If the CEO does steal, his utility is 0.8(V-$1)+$1=0.8V+0.2 • As a rational human, why not steal? • Lower the fraction of equity in the firm held by CEO, more the amount stolen in equilibrium. • In an extreme situation (CEO has zero ownership), he bears no cost at all but enjoys the whole benefit from stealing.

  6. Are shareholders fools? • Shareholders will anticipate such behavior if they are rational. • Therefore, if a CEO, who owned 100% equity to begin with, starts divesting, the valuation placed by outsiders on each 1% of equity he sells will be smaller as his equity-holding in the firm gets smaller. • In other words, it is ultimately the CEO himself who bears this agency cost of equity.

  7. What CEOs could do to limit the costs • CEOs have incentives to limit the “stealing” activities but it is not easy. • Stealing is not observable and contractible • A “promise” not to steal at the time of selling equity to outsiders is not credible (will be reneged upon later, shareholders know!)

  8. Mechanisms to reduce agency costs • Monitoring, by • Board of directors (independent directors) • Large shareholders/institutional investors • Banks, insurance companies, mutual funds, pension funds, private trust, and endowments • They hold almost 50% of equity claims of corporations. • Optimal executive compensation packages that link a large chunk of pay to stock price performance • Stock options • Performance-based bonus • High salary

  9. Debt as a way to mitigate agency problem (Jensen 1986, free cash flow theory) • Free cash flow: cash flow in excess of that required to fund all positive NPV projects. • Key idea: by issuing debt, managers are effectively committing to pay out future free cash flows. • Dividend increases have the same “commitment” effect but weaker: debt holders can take the firm to bankruptcy court if they renege! • Leveraged buyouts (LBOs) is an example of the benefits of reducing agency costs using debt.

  10. An example • Firm A is an all equity firm • Firm B is highly leveraged with senior debt, convertible debt, and common equity. • If management invests in value-reducing projects and the firm defaults on some interest payments, firm B shareholders as well as bondholders can step in. • Firm A shareholders can do nothing if the same situation happens and the firm reduces (or omits) the dividends.

  11. Shareholders Vs. Bondholders (Agency cost of debt) • Agency costs arise from conflicts of interest between stockholders (as a group) and bondholders (as a group). • Stockholders have an incentive to increase share value at the expense of the value of bonds (debt) • Most severe in firms with a high chance of bankruptcy • Empirical evidence shows that such costs are much higher than direct/indirect costs of bankruptcy (lawyer fees, loss of business, etc)

  12. An example • Assume the firm has a $30M debt outstanding and a cash of $35M available for investment . For simplicity, interest rate is zero. • Which project should be implemented? • Which project will shareholders implement? Why? • What is the value of debt with project S and project R, respectively? • What will the debt sell for?

  13. Mechanisms for controlling agency cost of debt • Debt covenants • Controls what shareholders can and cannot do • For example, dividends cannot be paid till debt payments outstanding. • Concept check: Who ultimately benefit from having debt covenants? • Convertible Bonds

  14. An Introduction to Convertible Bond • Debt with conversion feature (to equity), i.e., it gives the holder the right to exchange it for a given number of shares of stock anytime up to and including the maturity date of the bond. • Example: a convertible bond with face value of $1000. It is convertible to equity at $20 per share (conversion price). • Conversion ratio is the number of shares each bond is entitled to , which is 50 shares/bond in this case.

  15. Why convertibles? • Convertible bonds reduce agency costs by aligning the incentives of stockholders and bondholders. • It allows bondholders to share in the “upside” if shareholders choose risky project, which mitigate the risk shifting problem.

  16. An (big) example • Assume the firm has a $30M debt outstanding and a cash of $35M available for investment. For simplicity, interest rate is zero. • Which project should be implemented? • Which project will shareholders implement? Why? • What is the value of debt with project S and project R, respectively? • What will the debt sell for?

  17. An (big) example (cont’d) • How can we cope with this problem? • Bond covenants (not always useful) • Issue convertible bonds • Solving the problem using convertible debt. • Idea: Choose α of the convertible debt issue such that shareholders are induced to pick project S rather than project R, i.e., choose α so that bondholders will convert to equity if project R is chosen and successful. • Expected cash flow to shareholders from choosing project R will be .5*(1-α)*58+.5*0+35-30, and this has to be less or equal to expected cash flow to equity from choosing project S (we need to pick α to ensure this).

  18. An (big) example (cont’d) • Project R: bondholders convert to equity and shareholders’ payoffs= .5*(1-α)*58+.5*0+35-30 • Project S: bondholders do not convert and shareholders’ payoffs= .5*(40-30)+.5*0+35-25 • What we need is .5*(1- α)*58+.5*0+35-30≤.5*(40-30)+.5*0+35-25  α≥0.655

  19. An (big) example (cont’d) • For example, α=0.66 is chosen. What is the optimal conversion strategy for convertible bond holders? • Expected cash flow to shareholders • 0.5*(1-0.66)*58+0+35-30=14.86M if R is chosen • 0.5*(40-30)+0.5*0+35-25=15M if S is chosen • Equity holders will choose project S and the agency problem is solved!

  20. Empirical evidence: when are convertibles used? • Convertibles are used for firms with • High growth rates (more risky projects available) • High leverage (risk shifting problem is more severe) • Lower credit ratings (risk-shifting problem is more severe)

  21. Information Asymmetry: capital structure • Stock issues under symmetric (full) information • Value of a firm w/o new project = 1M; • New project’s NPV=0.5M; • Number of shares outstanding=50,000 • Investment required=0.6M • Value of firm=1M+.5M=1.5M • Price per share=1.5M/50,000=$30/share • If the firm sells 20,000 shares at this price, it can raise 20,000*30=.6M, which is needed for the investment. • Value of firm after equity issues =1.5M+0.6M=2.1M • Price per share=2.1M/70,000=$30/share • Lesson: share price does not change after equity issue (issuing correctly valued equity does not depress stock price) if information is symmetric.

  22. If the firm’s equity is undervalued… • If the firm has to sell equity at $20 per share (instead of the true value of $30) • No. of new shares to be issued=.6M/20=30,000 • Value of shares after investment=2.1M/80,000 =$26.25/share • Loss in value=30-26.25=$3.75/share • Lesson: firms will never issue equity if their stock is undervalued. • Implication: firms issue equity because their stock is overvalued. • Market reaction: issuing stocks is bad news and market prices the stock less. • Empirical evidence: on average, stock price falls by 3% upon the announcement of new equity issuing.

  23. More general case • Consider a firm consisting of assets in place and a positive NPV project (to be funded). Firm insiders (CEOs, management team) have private information about value of assets in place, but outsiders (investors, market) do not observe the true quality of the firm but believe that it could be either H or L with a certain probability. • Investment requirement=I • Cash flow from new project=C • Interest rate=r • No asymmetric information about new project value

  24. Finance the project with equity • Let S denote the fraction of equity that has to be offered to new shareholders in return for capital. • Then the expected cash flow after new project is implemented is .5*100+.5*50+C. • The present value of the fraction of the cash flow going to new shareholders is S(.5*100+.5*50+C)/(1+r) • This has to equal if the firm is to raise an amount I for investment by selling equity: • S(.5*100+.5*50+C)/(1+r)=I

  25. Example --1 • Assume r=10%, I=10, C=12 • Then investors will request S=12.6% of firm equity to be offered to them in exchange of I=10. • For firm insiders, equity issue makes sense if and only if (1-S)(π + C)≥ π, i.e., cash flow w/project ≥ cash flow w/o project. • Type H firm, if substitute π=100, C=12, S=0.126, we will get 97.88<100  not satisfied! • Type L firm, if substitute π=50, C=12, S=0.126 • We will get 51.188>50  satisfied!

  26. Example --1 (cont’d) • What does that mean? • Managers with very favorable private information would prefer to pass up positive NPV projects rather than issue equity. • Managers with less favorable private information, however, find it worthwhile to issue equity. • Are investors fools? • They will infer that the insider’s private information is rather unfavorable (type L firm) when a firm announces an equity issue. • A deeper question: what is S shareholders request then?

  27. Empirical implication of this theory • Equity-issue announcements are followed by a drop in share price, on average (since they convey bad news). • Confirmed by empirical studies: 3% drop • Firms will give up positive NPV projects because of asymmetric information in many cases. • Confirmed by CEO survey studies • Managers issue equity only if the NPV of the project given up is larger than any loss in value coming from the fall in share price (next slide).

  28. Example --2 • C=20, r=0.1 and I=10 (note only C changes) • Then outside investors require S=11/95=11.57% • Type H firms (1-0.1157)*(100+20)=106.12>100, satisfied! • Type L firms (1-0.1157)*(50+20)=61.9>50, satisfied! • Both types of firms issue equity if project’s NPV is large enough. • There is no negative announcement effect in this case (why?)

  29. Example --3 (finance the project with risk-less debt) • Let C=12 as in example--1 • If the firm can issue debt, the face value, F, of debt to be issued to finance the project. I=F/(1+r)  F=11 • Since 50>11, regardless of firm type, the debt can always be paid back, it is risk-free. • The managers will implement the project if and only if π+C-F ≥ π. Let’s check: • Type H: 100+12-11=101>100, satisfied! • Type L: 50+12-11=51>50, satisfied! • Both types issue debt and undertake the project.

  30. Example--3 (cont’d) • Lesson: while the type H firm would have passed up a positive NPV project if it had to finance with equity (in example--1), it would implement the project if it could finance with risk-free debt. • Question: why? Stock is most information sensitive and risk-free debt is less information sensitive. • Bondholders’ payoffs are fixed, and as long as bonds could be repaid, bondholders do not really care about firm’s value

  31. Pecking order theory (revisited) • Internal financing (retained earnings) has basically the same properties as risk-free debt: the firm would implement all positive NPV projects if it had enough internal financing available. • In general, it can be shown that there is a pecking order • Internal financing or riskless debt is most desirable to use • Risky debt, preferred equity are in-between in terms of loss in value • Equity (common equity) is least desirable.

  32. Information Asymmetry: dividend policy • Empirical evidence has documented that announcements of changes in a firm’s dividend policy result in dramatic changes in the firm’s share price. • Share price rises if firms increase dividends • Share price drops if firms cut dividends. • Several researchers have argued that dividend changes convey information from insiders to the firm, i.e., dividends act as “signals” of inside information.

  33. Example • Basic idea of signaling: actions speak louder than words. • At time 0 firm insiders obtain some private information about the level of firm’s future cash flow at time 1, which could be either H or L. • Also, firm needs to make investments in its projects at time 1. • If the time 1 cash flow is H, the firm can meet much of its time 1 investment requirement from this cash flow. • If the time 1 cash flow is L, the firm will have to issue new equity to raise this amount, thus incurring the large cost of equity issue (direct as well as indirect costs we discussed before).

  34. Example (cont’d) • If manager’s private information is not very favorable (their future cash flow may be L), they will conserve cash by cutting the dividend at time 0 itself. • Doing so can minimize the amount to be raised externally at time 1 and minimize the frictional costs arising from external financing. • If manager’s private information is favorable, they will maintain the current dividend level, or even raise the dividend. • Key point: the dividend policy chosen by the firm at time 0 conveys information about what insiders really expect earnings in the future to be! • Outsiders will react to this information rationally. • Share price drops dramatically if firms cut dividends • Share price increases if firms increase dividends.

  35. Sterling Bancshares Inc. Price Reaction to Dividend Cut Announcement

  36. Key Points • Agency problem arises from the conflict of interests • Shareholders Vs. Managers • Bondholders Vs. Shareholders • It is “the agent” who bears such agency costs. • Mangers (shareholders Vs. managers) • Shareholders (bondholders Vs. shareholders) • It is “the agent” who benefits from any mechanism that can effectively mitigate agency problems! • Information asymmetry • Capital Structure • Dividend Policy

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