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Lecture9 - capital structure theory

Lower on the other hand bond covenants are costly

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Unformatted text preview: Bond covenants – These reduce management’s ability to take These advantage of bondholders. This can actually be good for the manager because it gives lower borrowing cost. lower – On the other hand, bond covenants are costly Restrict management’s actions Monitoring is expensive – Expect to see covenants when their cost is Expect less than the agency costs that they prevent. 40 Agency Cost of Equity and the Free Agency Cash Flow Hypothesis Cash Note: before we argued that debt increases the agency Note: cost of debt, while here we will argue that debt helps to reduce the agency costs of equity – a benefit of debt! reduce Agency costs of equity arise because managers aren’t Agency owners (“ the 1/n problem”): owners – Less incentive to work hard (Managerial shirking) – May take more perks because they don’t bear the May costs (perk consumption) costs – May take negative NPV projects just to increase size, May since managerial pay is often linked to the size of the organization organization 41 Agency cost of equity Think of owner/manager trying to sell equity. He will then Think sell He 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) lower Owner/manager thus has incentives to reduce agency Owner/manager costs of equity costs – Can facilitate monitoring of her own activities Can (transparent accounting) (transparent – LBO’s put ownership more in managers hands LBO’s (eliminate the agency cost issue) (eliminate – Leverage increases responsiveness of stock price to Leverage managerial effort managerial – Monitoring by bond rating agencies 42 The Free Cash Flow Hypothesis Agency costs of equity will be more severe in firms with more Agency free cash flows (FCFs). free – A manager with excess cash will engage is wasteful activity. manager – A cash cushion reduces the consequences of managerial cash mistakes, so less incentive to exert effort. Debt commits managers to disburse the FCFs to lenders Debt – Reduces the FCFs under managerial discretion – Threat of bankruptcy forces managers to work hard – Capital markets rather than retained earnings provide Capital financing for new projects – increased monitoring financing – Monitoring from debt rating agencies 43 Summary...
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