Debt Covenants and Financial Reporting Standards . Debtholders receive note cont

Question

Debt Covenants and Financial Reporting Standards . Debtholders receive note contracts, one for each note, that describe the payments promised by the issuer of the debt. In addition, the issuing corporation frequently enters a supplementary agreement, called a note indenture, with a trustee who represents the debtholders. The provisions or covenants of the indenture may place restrictions on the issuer for the benefit of the debtholders. For example, an indenture may require that the issuer’s debt to equity ratio never rise above a specified level or that periodic payments be made to the trustee who administers a “sinking fund” to provide for the retirement of debt. Consider Roswell Manufacturing’s debt indenture, which requires that Roswell’s debt to equity ratio never exceed . If Roswell violates this requirement, the debt indenture specifies very costly penalties, and if the violation continues, the entire debt issue must be retired at a disadvantageous price and refinanced. In recent years, Roswell’s ratio has averaged about in total liabilities and in total stockholders’ equity). However, Roswell has an opportunity to purchase one of its major competitors, Ashland Products. The acquisition will require in additional liabilities, but it will double Roswell’s net income. Roswell does not believe that a stock issue is feasible in the current environment. The Financial Accounting Standards Board issued a new standard concerning accounting for post employment benefits, which is strongly supported by the Securities and Exchange Commission. Implementation of the new standard will add about to Roswell’s long-term liabilities. Roswell’s CEO, Martha Cooper, has written a strong letter of objection to the FASB. The FASB received similar letters from over companies. Required: 1.Write a paragraph presenting an analysis of the impact of the new standard on Roswell Manufacturing. 2.If you were a member of the FASB and met Martha Cooper at a professional meeting, how would you respond to her objection?

Explanation / Answer

Corporations are ‘legal fictions which serve as a nexus for a set of contracting relationships among individuals’.’ To focus on the contract between the bondholders and the corporation, we assume that costs of enforcing other contracts are zero. For example, we assume that contracts between stockholders and managers costlessly induce managers to act as if they own all the firm’s equity. The corporation has an indefinite life and the set of contracts which comprise the corporation evolves over time: as the firm’s investment opportunity set changes decisions are made about the real activities in which the firm engages and the financial contracts the firm sells. With risky bonds outstanding, management, acting in the stockholders’ interest, has incentives to design the firm’s operating characteristics and financial structure in ways which benefit stockholders to the detriment of bondholders. Because investment, financing, and dividend policies are endogenous, there are four major sources of conflict which arise between bondholders and stockholders: Dividend payment. If a lirm issues bonds and the bonds are priced assuming the firm will maintain its dividend policy, the value of the bonds is reduced by raising the dividend rate and financing the increase by reducing investment. At the limit, if the firm sells all its assets and pays a liquidating dividend to the stockholders, the bondholders are left with worthless claims. Claim dilution. If the firm sells bonds, and the bonds are priced assuming that no additional debt will be issued, the value of the bondholders’ claims is reduced by issuing additional debt of the same or higher priority.

The Costly Contracting Hypothesis is that control of the bondholderstockholder conflict through tinancial contracts can increase the value of the firm. Like the Irrelevance Hypothesis, the Costly Contracting Hypothesis recognizes the influence which external markets and the possibility of recapitalization exert on the firm’s choice of investment policy. However, this hypothesis presupposes that those factors, while controlling to some extent the bondholder-stockholder conflict, are insufficient to induce the stockholders to maximum

Stockholder use (or misuse) of production/investment policy frequently involves not some action, but the failure to take a certain action (e.g., failure to accept a positive net present value project). Because of this, investment policy can be very expensive to monitor, since ascertaining that the firm’s production/investment policy does not maximize the firm’s market value depends on magnitudes which are costly to observe. Solutions to this problem are not obvious. For example, if the indenture were to require the bondholders (rather than the stockholders) to establish the firm’s investment policy, the problem would not be solved; the bondholders, acting in their self interest, would choose an investment policy which maximized the value of the bonds, not the value of the firm. 27 In addition, there are other costs associated with giving bondholders a role in establishing the firm’s investment policy. For instance, as we discuss in section 3, legal costs can be imposed on bondholders if they are deemed to have assumed control of the corporation.

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