*different than other previsouly stated quesitons, my last quesitons are differe

ID: 2782021 • Letter: #

Question

*different than other previsouly stated quesitons, my last quesitons are different...**

Jensen and Meckling (1976) also provide potentially important insights into the choice of Capital Structure. They discuss Agency Conflicts and the Costs associated with these. Describe the Agency Conflicts between Corporate Managers and the Stockholders of the firm. Next, describe the Agency Conflicts between the Bondholders and Stockholders of a firm. Be sure to describe how the level of debt in capital structure will affect both types of agency conflicts. Describe how the trade-offs between the different classes of Agency Conflicts and Costs may produce an Optimal Capital Structure in the context of Jensen and Mecklings’ framework. Explain Michael Jensen’s notions of what types of firms should employ high levels of debt, and which should not. Describe two common bond covenants, and explain how they help to ameliorate conflict between bondholders and stockholders.

Explanation / Answer

BASIS

STOCKHOLDER

BOND HOLDER

MEANING

These are the financial instrument that carries the ownership interest, which has been issued by the company in an exchange with cash.

These are the debt instruments issued by the company for raising the capital with a promise to pay back after a certain period of interest.

WHAT ARE THEY?

They are equity instrument.

They are debt instrument.

RETURN

Dividend

Interest

RETURN GUARANTEE?

Yes

OWNER

These are the owner of Stockholder.

These are the owner of the bondholder.

RISK

Here the Risk is high.

Here the risk is comparatively low.

MARKET

These are the centralized market.

These are the over the counter (OTC).

Now Agency Conflict between Stockholder and Bondholder

Agency conflict occurs when the incentives of the agent do not align with those principals, or we can say that a conflict between two people as the other does not align with the principal.

These are key points that arise the conflict between stockholder and Bondholder.

Now the Framework of Jensen and Meckling describing the capital structure and how it will help to ameliorate conflict between bondholder and stockholders.

Jensen and Meckling: "Agency and Firms' Ownership Structure"

The focus is on the relationship between upper-level management and stockholders -- categories which overlap when the owner is the manager.

Although J&M believe that agency problems within the firm explain institutional decisions in other dimensions as well. They expand A&D beyond team production, then focus on a narrower scope.

The main thrust is in explaining ownership structure of the firm as an institution designed to limit agency costs.

Ownership structure: Is financing done through debt or equity markets?

Differences (simplifying):

We talked before of moral hazard/principal-agent problem/post-contractual opportunism.

In this context, shareholders and managers can have divergent interests.

Shareholders: maximize net present value of the firm

Managers: maximize utility, of which income is part

Managers may wish to take perquisites (company jets, big offices..)

Shareholders can imperfectly monitor these decisions.

Agency costs=monitoring costs+bonding costs+residual loss

Residual loss: loss incurred "by the principal" because the agent's decisions do not serve its interests.

Paper not concerned with how the principal can motivate agent.

Assumed that they can construct some incentive contract that is optimal given the agency problem that exists.

Look at contractual form between managers and share/bondholders in equilibrium.

Once again, the firm is not an individual, but a "nexus of contracts."

Agency Costs of Equity

Non-profit maximization even sole owners may not profit maximize, but this is efficient because they are maximizing utility and bear all of the costs of their decisions. If the sole owner wants a fancy computer, no problem...

If a manager is the enterprise's only residual claimant that there is no efficiency loss from perquisite-taking. One can interpret it as on-the-job consumption. The manager bears the full cost of any on the job consumption which decreases the pecuniary returns he receives from the enterprise.

Efficiency losses -- agency costs -- arise when managers do not bear the full consequences of their decisions.

Suppose now they are not the sole owner

This is the nature of agency costs from outside equity.

Who bears these costs? The agent!

Why? In selling equity shares, prospective buyers will realize the agency problem makes the shares worthless and will pay less for them. They will take into account the firm's value given the new ownership structure.

So it is in the agent's interest to devise a contract that limits the agency costs of equity.

Agency problem gets larger, the smaller the percentage of the firm that is owned by the manager...or, the greater amount that equity financing is relied upon.

Agency explanation also applies to managers' incentive to forego potentially profitable opportunities which require effort.

Agency costs vary with:

Why are there owners other than the manager? Investments exceed manager's wealth.

Having non-manager-owned shares introduces agency costs.

Agency costs of debt

Debt: fixed payments, the possibility of default in cases of bankruptcy.

What incentives does borrowing introduce? Excessive risk-taking.

Insulates manager from the full impact of decisions -- limits losses in bad states of the world.

Suppose:

Project A Investment Good Bad

$750 $1750 $750 E(profit)=$1250

debtholders $262.5 $262.5

stockholders $1487.5 $487.5 E(profit)=$987.5

Project B Investment Good Bad

$750 $2400 $0 E(profit)=$1200

debtholders $262.5 $0

stockholders $2137.5 $0 E(profit)=$1068.5

Manager chooses riskier project with lower expected value -- increase probability of default

monitoring and bonding can be used to reduce total agency costs

w/debt, also, there may be costs associated w/bankruptcy: legal fees, reorganization, etc.

agency cost of debt = monitoring+bonding+bankruptcy + residual losses

Who bears these costs, if capital markets are perfect? Manager/owner.

Equilibrium Ownership Structure

The fraction of outside financing from debt and equity. Given the amount of outside financing, minimize total agency costs.