Finance Lecture 16: Agency Theory and Asymmetric Info

Managers are generally more skilled in running the firm, allowing for better daily operations.

Agency problems arise from asymmetric information, leading to conflicts of interest between shareholders and managers.

Conflicts can arise when managers make decisions that favor stockholders, potentially at the expense of bondholders.

<p>Many shareholders lack the time, expertise, or ability to effectively run the firm on a day-to-day basis.</p> Signup and view all the answers

<p>Corporate governance establishes rules and practices to align the interests of management with those of shareholders.</p> Signup and view all the answers

<p>The choice of effort affects firm value by decreasing it with increasing nonpecuniary benefits, as indicated by the relationship $V(F) = V(X^*) - F$.</p> Signup and view all the answers

<p>The slope $\frac{\partial V(F)}{\partial F} = -1$ indicates a negative relationship where an increase in nonpecuniary benefits results in a corresponding decrease in firm value.</p> Signup and view all the answers

<p>A manager's utility of wealth is determined by firm value (V) and the nonpecuniary benefits (F) they receive.</p> Signup and view all the answers

<p>A manager's optimal choice of activity is to maximize their utility $U(V, F)$ given the $(V, F)$-constraint that allows them to achieve the highest wealth.</p> Signup and view all the answers

<p>One conflict between stockholders and bondholders is risk preference, where stockholders may prefer high-risk investments for greater returns, while bondholders favor stability to protect their fixed returns.</p> Signup and view all the answers

<p>Agency costs are the costs that arise from conflicts of interest between stakeholders, resulting in a loss in firm value due to agency problems.</p> Signup and view all the answers

<p>Direct costs include expenses related to luxury goods that benefit management and costs incurred in constructing managerial compensation contracts.</p> Signup and view all the answers

<p>Financing through outside equity increases agency problems, which in turn raises agency costs.</p> Signup and view all the answers

<p>Dividends can create conflicts when management increases payouts unexpectedly, funded by reducing assets or planned investments, which negatively affects bondholders.</p> Signup and view all the answers

<p>Indirect agency costs include lower issuing prices of equity and costs associated with management ignoring value-adding investments.</p> Signup and view all the answers

<p>Two main sources of conflict are dividend payouts and asset substitution.</p> Signup and view all the answers

<p>Monitoring costs are incurred to minimize agency problems and reduce agency costs associated with managerial actions.</p> Signup and view all the answers

<p>Corporate governance aims to minimize agency costs through mechanisms such as performance-based compensation and monitoring.</p> Signup and view all the answers

<p>Increased dividends increase equity value for stockholders.</p> Signup and view all the answers

<p>Bondholders face increased debt risk, which can reduce the value of existing debt.</p> Signup and view all the answers

<p>Claim dilution occurs when new debt is issued with the same or higher priority as existing debt, reducing the value of existing claims.</p> Signup and view all the answers

<p>A firm might offer increased dividends to enhance equity value, posing risk to bondholders.</p> Signup and view all the answers

<p>The value of existing debt decreases if a firm issues new debt with higher priority.</p> Signup and view all the answers

<p>The agency problem arises when managers favor actions that benefit stockholders at the expense of bondholders' interests.</p> Signup and view all the answers

<p>Underinvestment occurs when a firm avoids profitable projects to preserve cash for debt repayment, which can harm bondholders' interests.</p> Signup and view all the answers

<p>Corporate governance helps align interests of stockholders and bondholders by enforcing rules and transparency.</p> Signup and view all the answers

<p>An increase in F decreases the firm’s value, leading outside investors to pay less than $(1 - α)V^*$ to ensure no immediate loss.</p> Signup and view all the answers

<p>A zero-sum game indicates that any gain by the manager (seller) corresponds with a loss for the outside investors (buyers), resulting in no overall benefit for either party.</p> Signup and view all the answers

<p>This equation indicates that the total value of the firm, $V(F)$, equals the price paid by outside investors, $S$, plus the value that the manager retains through partial ownership, $αV(F)$.</p> Signup and view all the answers

<p>The manager experiences a welfare loss where their utility, $U_1$, is less than that of stockholders, $U_2$, due to conflicts arising from agency issues.</p> Signup and view all the answers

<p>Direct agency costs can be minimized through the costs of debt contracting, which includes implementing debt covenants to restrict managerial actions.</p> Signup and view all the answers

<p>The main sources of conflict include the choice of effort by managers, incentives to reduce firm risk, and differing time horizons between managers and stockholders.</p> Signup and view all the answers

<p>Debt financing increases agency problems which, in turn, raise agency costs, making debt less attractive for firms.</p> Signup and view all the answers

<p>A manager may ignore value-adding projects if they are deemed too risky, as it could jeopardize their job security and wealth, opposing shareholder interests.</p> Signup and view all the answers

<p>Managers often focus on short-term outcomes due to their limited tenure, which can lead them to disregard long-term cash flows beneficial for shareholders.</p> Signup and view all the answers

<p>Indirect agency costs can manifest as lower issuing prices of bonds and higher coupon rates for debt instruments.</p> Signup and view all the answers

<p>Internal controls are significant in corporate governance as they help ensure compliance, integrity in financial reporting, and mitigate the risk of agency problems.</p> Signup and view all the answers

<p>Agency costs are the difference between the potential value of the firm, $V^*$, and its actual value after addressing agency problems, $V'$; they represent welfare losses due to conflicting interests.</p> Signup and view all the answers

<p>Managerial interests can be aligned with shareholders' through compensation contracts based on stock prices or offering stock options.</p> Signup and view all the answers

<p>Monitoring costs are incurred to oversee managerial actions, and their increase contributes to overall agency costs faced by the firm.</p> Signup and view all the answers