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! Exploiting Debt Holders: The Agency Costs of Leverage The type of costs we describe in this section are examples of agency costs—costs that arise when there are conflicts of interest between stakeholders. When a firm has leverage, a conflict of interest exists if investment decisions have different consequences for the value of equity and the value of debt. Such a conflict is most likely to occur when the risk of financial distress is high. In some circumstances, managers may take actions that benefit shareholders but harm the firm’s creditors and lower the total value of the firm. When a firm is in financial distress and they have no other options left than a fairly risky strategy, equity holders will always promote this. They have nothing left to lose, because if the firm files for bankruptcy, they lose their whole investment. The debt holders lose: if the strategy fails, they bear the loss. Effectively, the equity holders are gambling with the debt holders’ money. When a firm faces financial distress, shareholders can gain from decisions that increase the risk of the firm sufficiently, even if they have a negative NPV. Because leverage gives shareholders an incentive to replace low-risk assets with riskier ones, this result is often referred to as the asset substitution problem. Debt Overhang and Under-Investment When a firm faces financial distress, it may choose not to finance new, positive-NPV projects. In this case, when shareholders prefer not to invest in a positive-NPV project (because most of the return will go to debt holders), we say there is a debt overhang or under-investment problem. This failure to invest is costly for debt holders and for the overall value of the firm, because it is giving up the NPV of the missed opportunities. The cost is highest for firms that are likely to have profitable future growth opportunities requiring large investments. When a firm faces financial distress, shareholders have an incentive to withdraw cash from the firm if possible. This incentive to liquidate assets at prices below their actual value to the firm is an extreme form of under-investment resulting from the debt overhang. cashing out. How much leverage must a firm have for there to be a significant debt overhang problem? While difficult to estimate precisely, we can use a useful approximation. Equity holders will benefit from the new investment only if: That is, the project’s profitability index (NPV/I) must exceed a cutoff equal to the relative riskiness of the firm’s debt (bD/bE) times its debt-equity ratio (D/E). Agency Costs and the Value of Leverage These examples illustrate how leverage can encourage managers and shareholders to act in ways that reduce firm value. In each case, the equity holders benefit at the expense of the debt holders. But, as with financial distress costs, it is the shareholders of the firm who ultimately bear these agency costs. Although equity holders may benefit at debt holders’ expense from these negative-NPV decisions in times of distress, debt holders recognize this possibility and pay less for the debt when it is first issued, reducing the amount the firm can distribute to shareholders. The net effect is a reduction in the initial share price of the firm corresponding to the negative NPV of the decisions. These agency costs of debt can arise only if there is some chance the firm will default and impose losses on its debt holders. The magnitude of the agency costs increases with the risk, and therefore the amount, of the firm’s debt. Agency costs, therefore, represent another cost of increasing the firm’s leverage that will affect the firm’s optimal capital structure choice. The Leverage Ratchet Effect Once a firm has debt already in place, some of the agency or bankruptcy costs that result from taking on additional leverage will fall on existing debt holders. The negative consequences for these debt