Implications for Agency Costs

The final consideration in designing securities is the provision of features intended to reduce the agency conflicts between stockholders and bondholders. As we noted in Chapter 7, differences between bondholders and stockholders on investment, financing and dividend policy decisions can influence capital structure decisions, either by increasing the costs of borrowing or by increasing the constraints associated with borrowing. In some cases, firms design securities with the specific intent of reducing this conflict and its associated costs:

• We explained that convertible bonds are a good choice for growth companies because of their cash flow characteristics. Convertible bonds can also reduce the anxiety of bondholders about equity investors investing in riskier projects and expropriating wealth, by allowing bondholders to become stockholders if the stock price increases enough.

• More corporate bonds include embedded put options that allow bondholders to put the bonds back at face value if the firm takes a specified action (such as increasing leverage) or if its rating drops. In a variation, in 1988, Manufacturer Hanover issued rating sensitive notes promising bondholders higher coupons if the firm's rating deteriorated over time. Thus, bond investors would be protected in the event of a downgrade.

• Merrill Lynch introduced LYONs (Liquid Yield Option Notes), which incorporated put and conversion features to protect against both the risk shifting and claim substitution to which bondholders are exposed.

Barclay and Smith (1996) examine debt issues by U.S. companies between 1981 and 1993 and conclude that high growth firms are more likely to issue short term debt with higher priority.21 This finding is consistent with both the information asymmetry argument and the agency cost argument, since lenders are more exposed to both costs with high growth firms.

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