Describe agency problems in general. Explain how capital structure and dividend policies can reduce or increase the agency problem.
The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests.
The agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager,
acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in
the manager’s best interest to maximize his own wealth.
Capital structure and div policy can reduce and increase the problem by determining how much money “will stay in the company”. For
example, the shareholders might be interested in getting a dividend for themselves, but the agents (the managers) would like to keep the money
as retained earnings and spend it on private jets for the company, expensive conferences and so on…
What actions can shareholders take when the corporation is underperforming and the board of directors is not aggressive in holding managers to
task?
If shareholders believe that the corporation is underperforming and the board of directors is not sufficiently aggressive in holding managers to
task, they can try to replace the board in the next election. The dissident shareholders will attempt to convince the other shareholders to vote for
their slate of candidates to the board. If they succeed, a new board will be elected and it can replace the current management team. Short of that,
unhappy shareholders can attempt to elect representatives to the board to make their voices heard.
Discuss what effect you would expect the following debt provisions to have on the yield that corporations must offer investors: funded (versus
unfunded) debt, sinking fund, call provision, subordinated debt, secured debt.
In times of a positively sloped yield curve, or even with mere uncertainty over future interest rates, one would expect that funded (i.e., long-
term) debt would require a higher yield than liabilities that will be paid off in one year. An investor should expect to receive a lower yield if the
debt has a sinking fund provision. Basically, this reduces the riskiness of the debt by eliminating the uncertainty over whether the firm can raise
the full amount of the principal for repayment at the time of final maturity. Debt that has a call provision will be likely to increase the yield that
issuers must offer to investors to hold the bonds. This is because investors can no longer be certain that they will collect the expected yield until
the final maturity. In return for uncertainty of return, investors will likely require more in initial yield. Investors who hold subordinated debt
should expect to receive higher yields because their investment is less secure than others. In the case of bankruptcy, subordinated debtholders
will join the general creditors of the firm rather than having claims on some specific assets. For the same reason, secured debt would be expected
to offer a lower yield than subordinated debt, due to the collateral value that, in effect, places a floor under which the value of the security should
not go.
List four protective covenants that you might be interested in as a prospective bondholder. Briefly describe why these would be realistic
bondholder concerns.
a. Limit either dollar value of total debt or debt as a percent of assets; as more debt is issued, it raises the risk of debtholders in general,
especially if some are subordinated.
b. Limit dividends either to a specific dollar amount or to a percent of net income; this may prevent shareholders from siphoning off funds prior
to an expected financial calamity.
c. Limit the issuance of preferred stock; this would only be necessary if the covenant listed in ‘b’ above specifically referred to common
dividends and made no mention of preferred dividends.
d. Limit the acquisition of assets under leasehold agreements; this may merely be a disguised form of debt.
