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7. Asymmetric Information And Agency Problem Notes

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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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