Managerial Incentives: Agency Costs and Corporate Scandals

Managerial Incentives

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Managerial Incentives Jörg Stahl Large part of the content is from Berk and DeMarzo , Corporate Finance, 3rd Edition Advanced Corporate Finance Jörg Stahl 1

Overview of the Lecture

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Managerial Incentives Overview of the lecture

• Exploiting Debt Holders: The Agency Costs of Leverage
• Motivating Managers: The Agency Benefits of Leverage Advanced Corporate Finance Jörg Stahl 2

Exploiting Debt Holders: The Agency Costs of Leverage

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Exploiting Debt Holders: The Agency Costs of Leverage . What are Agency Costs of Leverage? Advanced Corporate Finance Jörg Stahl 3

Agency Costs Defined

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Exploiting Debt Holders: The Agency Costs of Leverage Agency Costs

• Costs that arise when there are conflicts of interest between the firm's stakeholders

. Management will generally make decisions that increase the value of the firm's equity . However, when a firm has leverage, managers may make decisions that benefit shareholders but harm the firm's creditors and lower the total value of the firm · What decisions might that be? Advanced Corporate Finance Jörg Stahl 4

Excessive Risk-Taking and Asset Substitution

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Excessive Risk-Taking and Asset Substitution · Consider Baxter, Inc., which is facing financial distress . Baxter has a loan of $1 million due at the end of the year · Without a change in its strategy, the market value of its assets will be only $900,000 at that time, and Baxter will default on its debt Old Strategy Value of assets 900 Debt 900 Equity 0 Advanced Corporate Finance Jörg Stahl 5

New Risky Strategy Analysis

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Excessive Risk-Taking and Asset Substitution · Baxter is considering a new strategy . No upfront investment, but only a 50% chance of success · Success: Increase of value of the firm's assets to $1.3 million · Failure: Value of the firm's assets will fall to $300,000 · Should Baxter go ahead with the new strategy? New Risky Strategy Old Strategy Success Failure Value of assets 900 1300 300 Debt 900 1000 300 Equity 0 300 0 Advanced Corporate Finance Jörg Stahl 6

Debt Overhang and Under-investment

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Debt Overhang and Under-investment . Now assume Baxter does not pursue the risky strategy but instead is considering an investment opportunity that requires an initial investment of $100,000 and will generate a risk-free return of 50% Without New Project With New Project Existing assets 900 900 New project 150 Advanced Corporate Finance Jörg Stahl 7

Investment Opportunity and Funding

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Debt Overhang and Under-investment . If the current risk-free rate is 5%, this investment clearly has a positive NPV · What if Baxter does not have the cash on hand to make the investment? · Could Baxter raise $100,000 in new equity to make the investment? Without New Project With New Project Existing assets 900 900 New project 150 Advanced Corporate Finance Jörg Stahl 8

Cashing Out in Financial Distress

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Debt Overhang and Under-investment Cashing Out · When a firm faces financial distress, shareholders have an incentive to withdraw money from the firm if possible · Suppose Baxter has equipment it can sell for $25,000 at the beginning of the year and pay immediate cash dividend · Without the equipment, Baxter will shut down some operations and the firm will be worth only $800,000 at year-end . Although selling equipment reduces the value of the firm by$100,000, if it is likely that Baxter will default at year-end, this cost would be borne by debt holders Advanced Corporate Finance Jörg Stahl 9

Agency Costs and the Value of Leverage

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Agency Costs and the Value of Leverage · When a firm adds leverage to its capital structure, the decision has two effects on the share price · The share price benefits from equity holders' ability to exploit debt holders in times of distress · The debt holders recognize this possibility and pay less for the debt when it is issued, reducing the amount the firm can distribute to shareholders · Debt holders lose more than shareholders gain from these activities and the net effect is a reduction in the initial share price of the firm Advanced Corporate Finance Jörg Stahl 10

Impact on Optimal Capital Structure

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Agency Costs and the Value of Leverage Agency costs of debt represent another cost of increasing the firm's leverage that will affect the firm's optimal capital structure choice Advanced Corporate Finance Jörg Stahl 11

Mitigating Agency Costs of Debt

SAVERIOTATI CATOLICA LISBON BUSINESS & ECONOMICS Agency Costs and the Value of Leverage . What can firms do to mitigate the agency costs of debt? Advanced Corporate Finance Jörg Stahl 12

Debt Maturity and Covenants

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Debt Maturity and Covenants . The magnitude of agency costs often depends on the maturity of debt · With long-term debt, equity holders have more opportunities to profit at the debt holders' expense before the debt matures . E.g., if Baxter's debt were due today, the firm would be forced to default or renegotiate with debt holders before it could risk, fail to invest, or cash out . However, by relying on short-term debt the firm will be obligated to repay or refinance its debt more frequently

• Short-term debt may also increase the firm's risk of financial distress and its associated costs Advanced Corporate Finance Jörg Stahl 13

Debt Covenants

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Debt Maturity and Covenants

• Debt Covenants - Conditions of making a loan in which creditors place restrictions on actions that a firm can take . Covenants may - Limit the firm's ability to pay large dividends or restrict the types of investments that the firm can make - They also typically limit the amount of debt the firm can take on · By preventing management from exploiting debt holders, covenants may help to reduce agency costs . However, because covenants hinder management flexibility, they have the potential to prevent investment in positive NPV opportunities and can have costs of their own Advanced Corporate Finance Jörg Stahl 14

Exercise: Hawar International

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Exercise · Hawar International is a shipping firm - Current share price of $5.50 and 10 million shares outstanding - Hawar pays a corporate tax rate of 30% . Suppose Hawar announces plans to lower its corporate taxes by borrowing $20 million and repurchasing shares · Shareholders expect the change in debt to be permanent . If the only imperfection is corporate taxes, what will the share price be after this announcement? . Suppose the only imperfections are corporate taxes and financial distress costs. If the share price rises to $5.75 after the initial announcement, what is the PV of financial distress costs Hawar will incur as the result of this new debt? Advanced Corporate Finance Jörg Stahl 15

Exercise: Vacant Land Development

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Exercise · Consider a firm - Only asset is a plot of vacant land - Only liability is debt of $15 million due in one year

• Two alternative strategies: - 1. If left vacant, the land will be worth $10 million in one year - 2. Alternatively, the firm can develop the land at an upfront cost of $20 million. The developed land will be worth $35 million in one year Suppose the risk-free interest rate is 10%, assume all cash flows are risk-free, and assume there are no taxes . If the firm chooses not to develop the land, what is the value of the firm's equity today? What is the value of the debt today? · What is the NPV of developing the land? Advanced Corporate Finance Jörg Stahl 16

Equity Holders' Willingness to Invest

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Exercise · Consider a firm - Only asset is a plot of vacant land - Only liability is debt of $15 million due in one year

• Two alternative strategies: - 1. If left vacant, the land will be worth $10 million in one year - 2. Alternatively, the firm can develop the land at an upfront cost of $20 million. The developed land will be worth $35 million in one year Suppose the risk-free interest rate is 10%, assume all cash flows are risk-free, and assume there are no taxes · Suppose the firm raises $20 million from equity holders to develop the land. If the firm develops the land, what is the value of the firm's equity today? What is the value of the firm's debt today? · Given your answer to previous part, would equity holders be willing to provide the $20 million needed to develop the land? Advanced Corporate Finance Jörg Stahl 17

Exercise: Petron Corporation Strategy

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Exercise · Petron Corporation has to decide on a new corporate strategy · Four options, each with a different probability of success and total firm value in the event of success, as shown below: Strategy A B C D Probability of Success 100% 80% 60% 40% Firm Value if Successful (in $ million) 50 60 70 80 · Assume that for each strategy, firm value is zero in the event of failure . Which strategy has the highest expected payoff? Advanced Corporate Finance Jörg Stahl 18

Strategy Choice with Varying Debt Levels

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Exercise Strategy A B C D Probability of Success 100% 80% 60% 40% Firm Value if Successful (in $ million) 50 60 70 80

• Suppose Petron's management team will choose the strategy that leads to the highest expected value of Petron's equity. Which strategy will management choose if Petron currently has
• (i) No debt?
• (ii) Debt with a face value of $20 million?
• (ii Debt with a face value of $40 million?
• For simplicity, assume all risk is idiosyncratic, the risk-free interest rate is zero, and there are no taxes Advanced Corporate Finance Jörg Stahl 19

Expected Value of Equity and Firm

SAVERIOTATI CATOLICA LISBON BVSINESS & ECONOMICS Exercise . Suppose same setting as before but that Petron Corp. has debt with a face value of $40 million outstanding . For simplicity, assume all risk is idiosyncratic, the risk-free interest rate is zero, and there are no taxes Strategy A B C D Probability of Success 100% 80% 60% 40% Firm Value if Successful (in $ million) 50 60 70 80 · What is the expected value of equity, assuming Petron will choose the strategy that maximizes the value of its equity? What is the total expected value of the firm? Advanced Corporate Finance Jörg Stahl 20