Lectures Notes Finance first semester, Study notes of Economics

Download Lectures Notes Finance first semester and more Study notes Economics in PDF only on Docsity! Motivating Managers: The Agency Benefits of Leverage This separation of ownership and control creates the possibility of management entrenchment: facing little threat of being fired and replaced, managers are free to run the firm in their own best interests. As a result, managers may make decisions that benefit themselves at investors’ expense. Concentration of Ownership One advantage of using leverage is that it allows the original owners of the firm to maintain their equity stake. As major shareholders, they will have a strong interest in doing what is best for the firm. The costs of reduced effort and excessive spending on perks are another form of agency cost. These agency costs arise in this case due to the dilution of ownership that occurs when equity financing is used. As always, if securities are fairly priced, the original owners of the firm pay the cost. Using leverage can benefit the firm by preserving ownership concentration and avoiding these agency costs. Reduction of Wasteful Investment While ownership is often concentrated for small, young firms, ownership typically becomes diluted over time as a firm grows. First, the original owners of the firm may retire, and the new managers likely will not hold a large ownership stake. Second, firms often need to raise more capital for investment than can be sustained using debt alone. Third, owners will often choose to sell off their stakes and invest in a well-diversified portfolio to reduce risk. With such low ownership stakes, the potential for conflict of interest between managers and equity holders is high. Appropriate monitoring and standards of accountability are required to prevent abuse. Some financial economists explain a manager’s willingness to engage in negative-NPV investments as empire building. According to this view, managers prefer to run large firms rather than small ones, so they will take on investments that increase the size—rather than the profitability—of the firm. One potential reason for this preference is that managers of large firms tend to earn higher salaries, and they may also have more prestige and garner greater publicity than managers of small firms. Another reason that managers may over-invest is that they are overconfident. Even when managers attempt to act in shareholders’ interests, they may make mistakes. Managers tend to be bullish on the firm’s prospects and so may believe that new opportunities are better than they actually are. They may also become committed to investments the firm has already made and continue to invest in projects that should be cancelled. For managers to engage in wasteful investment, they must have the cash to invest. This observation is the basis of the free cash flow hypothesis, the view that wasteful spending is more likely to occur when firms have high levels of cash flow in excess of what is needed to make all positive-NPV investments and payments to debt holders. A related idea is that leverage can reduce the degree of managerial entrenchment because managers are more likely to be fired when a firm faces financial distress. Managers who are less entrenched may be more concerned about their performance and less likely to engage in wasteful investment. In addition, when the firm is highly levered, creditors themselves will closely monitor the actions of managers, providing an additional layer of management oversight. Leverage and Commitment Leverage may also tie managers’ hands and commit them to pursue strategies with greater vigor than they would without the threat of financial distress. A firm with greater leverage may also become a fiercer competitor and act more aggressively in protecting its markets because it cannot risk the possibility of bankruptcy.