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## 7. Asymmetric Information And Agency Problem Notes

This is an extract of our 7. Asymmetric Information And Agency Problem document, which we sell as part of our Corporate Finance Notes collection written by the top tier of University Of London (examined By LSE) students.

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Asymmetric Information and Agency Problem
Asymmetric Information, Agency Costs and Capital Structure
Jensen and Meckling (1976)
Agency Problem (Violation of MM1)
 Separation between ownership and control
 Stakeholders' objectives  Manager's Objective
 Objectives of Stakeholders: To maximize wealth
 Objective of Managers: To maximize own utility
Agency Costs
 Agency cost of equity
 Agency cost of debt
Agency Cost of Equity (Principal-agent Problem)
Principal = Stakeholders
Agent = Manager
Outside Equity () = Equity held by Shareholders
Inside Equity (1 - ) = Equity held by Manager
Total Equity = Outside Equity + Inside Equity
Agency Cost = Cost associated with Outside Equity
Effort of Agent, Firm Value
(1 - ), Effort of Agent
If , then (1 - ), Effort of Agent, Firm Value,
Hence, Agency Cost
If , then (1 - ), Effort of Agent, Firm Value
Hence, Agency Cost
MM1 is violated as capital structure may alter firm value

1 Repurchase of Outside Equity by Issuing Debt
(D/E)  (1 - ), Effort of Agent, Agency Cost, Firm Value
Agency Cost

Agency Cost of Equity

D/E

Agency Cost of Debt (Asset Substitution or Risk-shifting)
 A problem that arises when a company exchanges its low-risk assets for high-risk investments.
 The transfer of assets places more risk on the debt holders without providing them with additional compensation.
 High-risk projects can yield higher profits, however more risk is incurred by the firm.
 The added profit may only benefit the shareholders, as the bondholders require only a fixed return.
Assumptions
 Managers act in the interest of existing equity-holders
 No agency cost associated with outside equity
 Firm borrows debt to finance its projects
 Debt-holders have priority to receive payoffs than equity-holders
State 1

State 2

State 3

Probability

P(1)

P(2)

P(3)

Cash Flow of Project A

A(1)

A(2)

A(3)

Cash Flow of Project B

B(1)

B(2)

B(3)

E(A) = P(1) x A(1) + P(2) x A(2) + P(3) x A(3)
E(B) = P(1) x B(1) + P(2) x B (2) + P(3) x B(3)
Cost of Capital = R
PV of E(A) = E(A) / (1 + R)
PV of E(B) = E(B) / (1 + R)

2 Project Risk Level = Variance Range
Variance Range = Highest Cash Flow - Lowest Cash Flow

Scenario
State 1

State 2

State 3

0.25 0.5

0.25 Cash flow of Project A

40 50

60 Cash flow of Project B

20 40

80 Probability

Cost of Capital

0%

E(A) = 0.25 x 40 + 0.5 x 50 + 0.25 x 60 = 50
E(B) = 0.25 x 20 + 0.5 x 40 + 0.25 x 80 = 45
PV of E(A) = 50 / (1 + 0) = 50
PV of E(B) = 45 / (1 + 0) = 45
Project B has a lower present value of cash flow
Variance Range of Project A = 60 - 40 = 20
Variance Range of Project B = 80 - 20 = 60
Project B has a higher variance and hence is more risky
Debt Obligation = Debt
Payoff

Equity-holder

Debt-holder

Cash Flow > Debt

Cash Flow - D

D

Cash Flow = Debt

0 D

Cash Flow < Debt

0 Cash Flow

Case 1: Debt Obligation = 50
Equity-holders

State 1

State 2

State 3

0.25 0.5

0.25 Payoff of Project A

40 - 50  0

50 - 50  0

60 - 50  10

2.5 Payoff of Project B

20 - 50  0

40 - 50  0

80 - 50  30

7.5 State 1

State 2

State 3

E(Payoff)

0.25 0.5

0.25 40  40

50  50

60  50

Probability

Debt-holders (50)
Probability
Payoff of Project A

E(Payoff)

47.5 3

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