AGENCY COST OF EQUITY
COSTS ARISING FROM THE FACT
THAT CORPORATE MANAGERS (CEOs,
FOR EXAMPLE) MAY MAXIMIZE
THEIR OWN VALUE
(UTILITY/SATISFICATION) AT THE
EXPENSE OF THEIR PRINCIPALS
(SHAREHOLDERS).
CEOs ARE “AGENTS” OF FIRM
SHAREHOLDERS, BUT THEIR
INTERESTS MAY NOT BE FULLY
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ALIGNED WITH SHAREHOLDER
INTERESTS.
 AGENCY PROBLEMS ARISE WHEN
CEO HAS LESS THAN 100% OF
EQUITY.
EXAMPLE
*ASSUME CEO CAN STEAL
RESOURCES (OR ENGAGE IN
NEGATIVE NPV ACTIVITIES THAT
PLEASE HIM.
*MANAGER’S UTILITY FUNCTION:
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U(WEALTH IN SHARE VALUE+
AMOUNT STOLEN)
*NOW, IF TOP MANAGEMENT HAS
100% EQUITY IN FIRM, NO INCENTIVE
TO STEAL
*THIS IS BECAUSE FOR EVERY $1 HE
STEALS, SHARE VALUE DROPS BY $1,
SO HE IS WORSE OFF THAN IF HE DID
NOT STEAL.
*ASSUME CEO EQUITY HOLDING IS
80%. NOW, IF FIRM VALUE
CORRESPONDING TO NO-STEALING
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BY THE CEO IS V, CEO HAS
INCENTIVE TO STEAL, AS SHOWN
BELOW:
ASSUMING RISK NEUTRAL CEO AND
INVESTORS,
UTILITY OF CEO IF HE STEALS $1 =
U{0.8(V - $1) + $1} = 0.8V - 0.8 + $1
{AMOUNT STOLEN}
= 0.8V + 0.2
CEO’S UTILITY IF HE DOESN’T STEAL
= U(0.8V) = 0.8V
VALUE OF EQUITY HELD BY HIM
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*IN PRACTICE, THE COST TO THE
FIRM FROM EACH DOLLAR OF
WASTEFUL ACTIVITY UNDERTAKEN
WILL BE GREATER THAN $1.
*WHAT WILL BE THE AMOUNT
STOLEN? DETERMINED BY:
MARGINAL BENEFIT TO CEO FROM
STEALING NEXT DOLLAR
= MARGINAL COST TO CEO ARISING
FROM A REDUCTION IN HIS EQUITY
VALUE.
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*LOWER THE FRACTION OF EQUITY
IN THE FIRM HELD BY CEO, MORE
THE AMOUNT STOLEN IN
EQUILIBRIUM (SINCE THE CEO WILL
BEAR ONLY A LOWER FRACTION OF
THE COST TO THE FIRM FROM HIS
STEALING!)
*BUT OUTSIDE SHAREHOLDERS ARE
NOT FOOLS : IF THEY ARE RATIONAL,
THEY WILL ANTICIPATE SUCH
BEHAVIOR (AT LEAST PARTLY).
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*THUS, IF A CEO, WHO OWNED 100%
EQUITY TO BEGIN WITH, STARTS
DIVESTING, THE VALUATION
PLACED BY OUTSIDERS ON EACH 1%
OF EQUITY HE SELLS WILL BE
SMALLER AS HIS EQUITY-HOLDING
IN THE FIRM GETS SMALLER.
*IN OTHER WORDS, IT IS
ULTIMATELY THE CEO/LARGE
SHOLDER HIMSELF WHO BEARS THIS
AGENCY COST OF EQUITY (SINCE
OUTSIDE SHARE HOLDERS
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ANTICIPATE HIS ACTIONS AND PRICE
EQUITY CORRECTLY)!
*THIS MEANS THAT THE CEO, OR
CONTROLLING SHARE HOLDER, HAS
AN INCENTIVE TO LIMIT THESE
COSTS.
*HOWEVER, DOING THIS IS NOT
EASY, SINCE MOST SUCH “STEALING”
ACTIVITIES ARE NONCONTRACTIBLE
(BECAUSE THEY ARE NONOBSERVABLE).
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*A “PROMISE” NOT TO STEAL AT THE
TIME OF SELLING EQUITY TO
OUTSIDERS IS CLEARLY NOT
CREDIBLE (WILL BE RENEGED UPON
LATER, SHARE HOLDERS KNOW!).
AGENCY COSTS OF EQUITY CAN BE
REDUCED BY:
(I) MONITORING, BY:
(i) BOARD OF DIRECTORS
(ii) LARGE SHARE
HOLDERS/INSTITUTIONAL
INVESTORS.
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(II) OPTIMAL (AT LEAST BETTER)
EXECUTIVE COMPENSATION
PACKAGES, THAT LINK A LARGE
CHUNK OF PAY TO STOCK PRICE
PERFORMANCE.
FINANCIAL INSTITUTIONS: BANKS &
SAVINGS INSTITUTIONS, INSURANCE
COMPANIES, MUTUAL FUNDS,
PENSION FUNDS, INVESTMENT
COMPANIES, PRIVATE TRUSTS &
ENDOWMENTS HOLD:
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ALMOST 50% OF EQUITY CLAIMS OF
CORPORATIONS
- 80% OF CORP BONDS
- 60-70% OF LARGE BLUECHIP
EQUITIES.
CALPERS AND CORPORATE
GOVERNANCE
-CALPERS CORPORATE
GOVERNANCE AGENDA
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(I) ISSUES IMPAIRING ABILITY OF
SHAREHOLDERS TO SELECT THE
BEST DIRECTORS
(II) ISSUES RELATING TO DIRECTORS’
(BOARD’S) ABILITY TO SUPERVISE
MANAGEMENT
(III) ISSUES RELATING TO ANY
DIVERGENCE OF INTEREST BETWEEN
SHAREHOLDERS AND FIRM
MANAGEMENT/BOARD.
ORGANIZATIONAL CONSTRAINTS
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- ACTIVE, LARGE BETS ON
COMPANIES MIGHT BE A POLITICAL
LIABILITY.
- LOW PAYING JOBS FOR PORTFOLIO
MANAGERS.
- NOT ENOUGH STAFF
- RESTRICTED TRAVEL AND OTHER
BUDGET
- EXPERTISE LIMITED?
- GOING TOO FAR MIGHT INDUCE
CEO TO COMPLAIN TO GOVERNOR
OR LEGISLATURE
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EXAMPLE OF LARGE
(INSTITUTIONAL) SHAREHOLDER
MONITORING: CALPERS
ON AVERAGE, PERFORMANCE BY
FIRMS CALPERS IS INVOLVED IN
SEEM TO HAVE DRAMTICALLY
IMPROVED (AS MEASURED BY
CUMULATIVE EXCESS RETURN
RELATED TO S&P 500 INDEX).
[SEE CAPLERS ARTICLE ON READING
LIST]
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PERFORMANCE - IMPROVEMENT IS
IN 1990-92 PERIOD, WHEN CALPERS
TARGED CORPORATE PERFORMANCE
EXPLICITLY (AS AGAINST 1987-89,
WHEN ANTI-TAKEOVER PROVISIONS
WERE THE FOCUS).
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DEBT AS A WAY OF MITIGATING THE
AGENCY COST OF EQUITY (FREE
CASH FLOW): JENSEN (1986)
FREE CASH FLOW: CASH FLOW IN
EXCESS OF THAT REQUIRED TO
FUND ALL POSITIVE NPV PROJECTS.
*THE IDEA: BY ISSUING DEBT IN
EXCHANGE FOR STOCK (i.e.,
WITHOUT INCREASING CASH FLOW)
MANAGERS ARE EFFECTIVELY
COMMITTING TO PAY OUT FUTURE
FREE CASH FLOWS.
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*THE SAME “COMMITMENT” EFFECT
IS NOT OBTAINABLE FROM
DIVIDEND INCREASES: DEBT
HOLDERS CAN TAKE THE FIRM TO
BANKRUPTCY COURT IF THE
RENEGE!
E.g: LEVERAGED BUYOUTS; AN
EXAMPLE OF THE BENEFITS OF
REDUCING AGENCY COSTS USING
DEBT.
COMPARE TWO FIRMS:
FIRM A: ALL EQUITY
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FIRM B: HIGHLY LEVERAGED, WITH
SENIOR DEBT, CONVERTIBLE DEBT,
PREFERRED AS WELL AS COMMON
EQUITY. (ASSUME STRIP FINANCING)
BOTH SECURITY HOLDERS HAVE
SAME CASH DISTRIBUTION, BUT
DIFFERENT ORGANIZATIONALLY
*FIRM B SHAREHOLDERS CAN STEP
IN IF MANAGEMENT INVESTS IN
VALUE-REDUCING PROJECTS AND
THE FIRM DEFAULTS ON SOME
INTEREST PAYMENTS.
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*EMPIRICAL EVIDENCE FROM OIL
INDUSTRY SEEMS TO BE
CONSISTENT WITH THIS: POSTIVE
MARKET RESPONSE TO DEBT
CREATION IN OIL-INDUSTRY TAKEOVERS.
UNFORTUNATELY, DEBT CAN
CREATE ITS OWN AGENCY
PROBLEMS, AS WE WILL NOW
DISCUSS.
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AGENCY COSTS OF DEBT
COSTS ARISING TO THE FIRM FROM
CONFLICTS OF INTEREST BETWEEN
STOCKHOLDERS (AS A GROUP) AND
BOND HOLDERS (AS A GROUP).
*MOST SEVERE IN FIRMS WITH A
HIGH PROBABILITY (CHANGE) OF
BANKRUPTCY.
*IN FACT, MANY STUDIES INDICATE
THAT SUCH COSTS ARE MUCH
HIGHER THAN DIRECT COSTS OF
BANKRUPTCY. (LAWYER FEES, ETC).
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*ARISES FROM THE FACT THAT IN
HIGH-LEVERAGE FIRMS,
STOCKHOLDERS HAVE AN
INCENTIVE TO INCREASE SHARE
VALUE AT THE EXPENSE OF THE
VALUE OF BONDS (DEBT).
EXAMPLE: FIRM CHOOSES BETWEEN
TWO MUTUALLY EXCLUSIVE
PROJECTS:
ASSUME: FACE VALUE OF DEBT
= $100
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PROJECT A: LOW-RISK
PROBABILITY
FIRM VALUE
STOCK VALUE
BOND VALUE
RECESSION
0.5
100
0
100
BOOM
0.5
200
100
100
EXPECTED VALUE
150
50
100
PROJECT B: HIGH-RISK
PROBABILITY
FIRM VALUE
STOCK VALUE
BOND VALUE
RECESSION
0.5
50
0
50
BOOM
0.5
240
140
100
EXPECTED VALUE
145
70
75
WHICH ONE WILL STOCK HOLDERS
PICK? PROJECT B, BECAUSE IT
INCREASES EQUITY VALUE!
WHICH ONE MAXIMIZES TOTAL FIRM
VALUE? PROJECT A.
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*BUT BOND HOLDERS ARE NO FOOLS
 THEY ANTICIPATE STOCK HOLDER
BEHAVIOR
*PRICE PAID FOR DEBT = $75 ONLY
SO STOCKHOLDERS BEAR THE
AGENCY COST.
*AGENCY COST OF DEBT
= VALUE OF ALL EQUITY FIRM
- VALUE OF LEVERED FIRM
= 150 - 145 = $5
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EXAMPLE-II
WITHOUT PROJECT.
WITH PROJECT.
BOOM
RECESSION
BOOM
RECESSION
0.5
0.5
0.5
0.5
FIRM CASH FLOW
5000
2400
6700
4100
BOND CASH FLOW
4000
2400
4000
4000
STOCK CASH FLOW
1000
0
2700
100
PROMISED DEBT PAYMENT = $4000
INVESTMENT REQUIRED FOR
PROJECT = $1000
ADDITIONAL CASH FLOW FROM
PROJECT = $1700
EXPECTED CASH FLOW TO EQUITY
HOLDERS WITHOUT PROJECT
= 0.5(1000) + 0.5(0) = 500
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EXPECTED CASH FLOW TO EQUITY
HOLDERS WITH PROJECT
= 0.5(2700) + 0.5(100) = 1400
BUT STOCK HOLDERS WON’T TAKE
PROJECT IF THEY HAVE TO FINANCE
IT THROUGH EQUITY (NEW EQUITY
OR CUTTING DIVIDEND) BECAUSE
STOCKHOLDER CASH FLOW GOES UP
BY ONLY $900 = 1400 - 500 WHILE
COSTING $1000 TO EQUITY HOLDERS.
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*NOTICE THAT AN ALL EQUITY FIRM
WOULD INVEST IN THE PROJECT
SINCE THE PROJECT IS +NPV
 ASSUMING r = 0, NPV = 1700 - 1000
= $700
AGENCY COST OF DEBT HERE
= NPV FOREGONE DUE TO DEBT IN
THE CAPITAL STRUCTURE
= $700
*THE FIRST EXAMPLE IS REFERRED
TO AS “RISK-SHIFTING”
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*THE SECOND EXAMPLE IS
REFERRED TO AS
“UNDERINVESTMENT”
*CONTROLLING AGENCY COST OF
DEBT:
- PRIME TOOL  DEBT COVENANTS
- CONTROLS WHAT EQUITY HOLDERS
CAN AND CANNOT DO.
- DIVIDENDS CANNOT BE PAID WILL
DEBT PAYMENTS OUTSTANDINGS OR
DELINQUENT (OBVIOUS).
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