Tut_01_A

Tut_01_A - SCHOOL OF BANKING AND FINANCE FINS5514 CAPITAL...

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1 SCHOOL OF BANKING AND FINANCE FINS5514 CAPITAL BUDGETING AND FINANCIAL DECISIONS TUTORIAL COVERING WEEK 1 – AGENCY THEORY SOLUTIONS 1. Outline some of the factors that lead to an increase in agency costs within a firm. Manager/Shareholder conflict Direct Agency costs : 1. Managers act in their own self-interest, reducing the firm’s value to shareholders. 2. Managers need to be monitored to ensure their actions are in the owners’ best interests. This generates monitoring costs. 3. Money is spent setting up contracts to control managers. This generates bonding costs. Indirect agency costs : 1.The opportunity cost when value maximising investment opportunities are rejected. Shareholder/Debtholder conflict 1. Asset substitution An agency problem arises if a firm elects a very risky project. This increases the required rate of return on debt but decreases the value of the creditors existing debt. If the project is a success, the shareholders will benefit. The creditors do not receive any extra return. If the project fails, the firm may not be able to pay its creditors. If a firm continues to behave in this manner, then the creditors may refuse to invest in the future or will demand higher rates of interest. 2. If a firm increases its borrowings based on the same assets 3. Increases dividends significantly or in the extreme, paying all its cash to shareholders as dividends To protect themselves, creditors may demand that restrictive covenants be written into
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Tut_01_A - SCHOOL OF BANKING AND FINANCE FINS5514 CAPITAL...

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