Unformatted text preview: Bond covenants
– These reduce management’s ability to take
advantage of bondholders. This can actually
be good for the manager because it gives
lower borrowing cost.
– On the other hand, bond covenants are costly
Restrict management’s actions
Monitoring is expensive
– Expect to see covenants when their cost is
less than the agency costs that they prevent.
40 Agency Cost of Equity and the Free
Cash Flow Hypothesis
Note: before we argued that debt increases the agency
cost of debt, while here we will argue that debt helps to
reduce the agency costs of equity – a benefit of debt!
Agency costs of equity arise because managers aren’t
owners (“ the 1/n problem”):
– Less incentive to work hard (Managerial shirking)
– May take more perks because they don’t bear the
costs (perk consumption)
– May take negative NPV projects just to increase size,
since managerial pay is often linked to the size of the
41 Agency cost of equity
Think of owner/manager trying to sell equity. He will then
become more of a manager and less of an owner. Any
purchaser of the new equity will understand the agency
costs involved, and demand a higher rate of return (so a
lower price for the equity)
Owner/manager thus has incentives to reduce agency
costs of equity
– Can facilitate monitoring of her own activities
– LBO’s put ownership more in managers hands
(eliminate the agency cost issue)
– Leverage increases responsiveness of stock price to
– Monitoring by bond rating agencies
42 The Free Cash Flow Hypothesis
Agency costs of equity will be more severe in firms with more
free cash flows (FCFs).
– A manager with excess cash will engage is wasteful activity.
– A cash cushion reduces the consequences of managerial
mistakes, so less incentive to exert effort.
Debt commits managers to disburse the FCFs to lenders
– Reduces the FCFs under managerial discretion
– Threat of bankruptcy forces managers to work hard
– Capital markets rather than retained earnings provide
financing for new projects – increased monitoring
– Monitoring from debt rating agencies
View Full Document