Debt creates agency costs

Equity investors, who receive a residual claim on the cash flows, tend to favor actions that increase the value of their holdings, even if that means increasing the risk that the bondholders (who have a fixed claim on the cash flows) will not receive their promised payments. Bondholders, on the other hand, want to preserve and increase the security of their claims. Since the equity investors generally control the firm's management and decision making, their interests will dominate bondholder interests unless bondholders take some protective action. By borrowing money, a firm exposes itself to this conflict and its negative consequences and it pays the price in terms of both higher interest rates and a loss of freedom in decision making.

The conflict between bondholder and stockholder interests appears in all three aspects of corporate finance: (1) deciding what projects to take (making investment decisions), (2) choosing how to finance these projects and (3) determining how much to pay out as dividends:

□ Risky projects: In the section on investment analysis, we argued that a project that earn a return that exceed the hurdle rate, adjusted to reflect the risk of the project, should be accepted and will increase firm value. The caveat, though, is that bondholders may be hurt if the firm accepts some of these projects.

Bondholders lend money to the firm with the expectation that the projects accepted will have a certain risk level, and they set the interest rate on the bonds accordingly. If the firm chooses projects that are riskier than expected, however, bondholders will lose on their existing holdings because the price of the holdings will decrease to reflect the higher risk.

□ Subsequent Financing: The conflict between stockholder and bondholder interests also arises when new projects have to be financed. The equity investors in a firm may favor new debt, using the assets of the firm as security and giving the new lenders prior claims over existing lenders. Such actions will reduce the interest rate on the new debt. The existing lenders in a firm, obviously do not want to give new lenders priority over their claims, because it makes the existing debt riskier (and less valuable). A firm may adopt a conservative financial policy and borrow money at low rates, with the expectation of keeping its default risk low. Once it has borrowed the money, however, the firm might choose to shift to a strategy of higher debt and default risk, leaving the original lenders worse off.

RiskShifting: Risk shifting refers to the tendency of stockholders in firms and their agents (managers) to take on much riskier projects than bondholders expect them to.

□ Dividends and Stock Repurchases: Dividend payments and equity repurchases also divide stockholders and bond holders. Consider a firm that has built up a large cash reserve but has very few good projects available. The stockholders in this firm may benefit if the cash is paid out as a dividend or used to repurchase stock. The bondholders, on the other hand, will prefer that the firm retain the cash, since it can be used to make payments on the debt, reducing default risk. It should come as no surprise that stockholders, if not constrained, will pay the dividends or buy back stock, overriding bondholder concerns. In some cases, the payments are large and can increase the default risk of the firm dramatically.

The potential for disagreement between stockholders and bondholders can show up in as real costs in two ways:

a. If bondholders believe there is a significant chance that stockholder actions might make them worse off, they can build this expectation into bond prices by demanding much higher interest rates on debt.

b. If bondholders can protect themselves against such actions by writing in restrictive covenants, two costs follow -

• the direct cost of monitoring the covenants, which increases as the covenants become more detailed and restrictive.

• the indirect cost of lost investments, since the firm is not able to take certain projects, use certain types of financing, or change its payout; this cost will also increase as the covenants becomes more restrictive.

As firms borrow more and more and expose themselves to greater agency costs, these costs will also increase.

Since agency costs can be substantial, two implications relating to optimal capital structure follow. First, the agency cost arising from risk shifting is likely to be greatest in firms whose investments cannot be easily observed and monitored. For example, a lender to a firm that invests in real estate is less exposed to agency cost than is a lender to a firm that invests in people or intangible assets. Consequently, it is not surprising that manufacturing companies and railroads, which invest in substantial real assets, have much higher debt ratios than service companies. Second, the agency cost associated with monitoring actions and second-guessing investment decisions is likely to be largest for firms whose projects are long term, follow unpredictable paths, and may take years to come to fruition. Pharmaceutical companies in the United States, for example, which often take on research projects that may take years to yield commercial products, have historically maintained low debt ratios, even though their cash flows would support more debt.

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