(1) Understand the complexity of the modern corporation as a network of many implicit as well as explicit contractual relationships.

(2) Identify the most significant implicit contractual relationships.

(3) Understand how many situations can be described as though they were a principal-agent relationship.

(4) Analyze situations in a principal-agent framework in terms of decision-making authority and control to identify the incentives for each side of a contract, and determine the impact of those incentives.

(5) Identify areas of naturally occurring conflicts of interest where incentives diverge.

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(1) The set-of-contracts model of the firm highlights the complexity of the modern corporation.

(a) The model was developed by using agency theory, which is the analysis of principal-agent relationships.

(b) Stakeholder claims on a firm can be described as a principal-agent relationship where an agent is acting on behalf of a principal.

(c) Many situations involve a principal-agent relationship.

(i) Some of the more visible explicit principal-agent relationships are those that principals enter into with money managers, lawyers, and real estate, travel, and insurance agents.

(ii) Many other situations can be described in the principal-agent framework as though the two parties were principal and agent, even though one party is not literally an agent for the other (e.g., most employees act as agents at some point).

(2) A potential conflict between the interests of the agent and those of the principal creates an agency problem.

(a) From the principle of self-interested behavior, we know that agents may be tempted to put their own self-interest ahead of those of the principal.

(b) Agency problems occur because of asymmetric information.

(3) If it were possible and not unreasonably costly for the principal to monitor the agent's actions perfectly, there would be no agency problems.

(a) Thus, contracts rarely have perfect monitoring and the problem of moral hazard can arise.

(b) Moral hazard occurs whenever agents can take unobserved actions in their own interest to the detriment of the principal.

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(1) Alternatives to monitoring include constraints, incentives, and punishments that encourage an agent to act in the principal's best interests.

(a) The costs of monitoring and other alternatives are called agency costs.

(b) Agency costs are the extra costs of having an agent act for a principal (those in excess of what it would cost the principals to do it themselves).

(c) Agency costs are defined in terms of the principle of incremental benefits where the agency cost is the incremental cost of working though others who serve as agents.

(2) Agency costs are of three types.

(a) Direct contracting costs include the following.

(i) The transaction costs of setting up the contract, such as the selling commissions and legal fees of issuing bonds.

(ii) The opportunity costs imposed by constraints that preclude otherwise optimal decisions (for example, an inability to make a positive NPV investment because of a restrictive bond covenant).

(iii) The incentive fees, such as employee bonuses, paid to the agent to encourage behavior consistent with the principal's goals.

(b) The costs to the principal of monitoring the agent (for example, auditing cost).

(c) The loss of wealth the principal suffers as a result of misbehavior in spite of monitoring, such as unidentified excessive employee expense accounts.

(3) A major goal is to find the contract that minimizes the relationship's total agency costs. The optimal contract transfers the decision-making authority in the most efficient way.

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(1) The stockholder-manager relationship is created by separating ownership and control.

(a) In practice, managers are the primary decision makers.

(b) They have considerable control over the firm and its assets.

(2) Manager-agent goals may differ from the stockholder-principal goal of maximizing stockholder wealth.

(a) Managers are alleged to favor growth and large size for a variety of reasons.

(b) Salary, power and status for managers are all positively correlated with the size and growth of the firm.

(3) One of the most obvious examples of moral hazard (the possibility of agent misbehavior) involves employee decisions that affect personal benefits, or perquisites.

(a) These include direct benefits, such as the use of a company car or expense account for personal business.

(b) Indirect benefits include excessively fancy office decorations.

(4) The problem of an agent putting forth less than full effort is referred to as shirking.

(5) The unique capabilities and expertise of individuals are referred to as human capital.

(a) Individuals become specialists in the firm they serve.

(b) This creates a problem called the nondiversifiabililty of human capital.

(c) Employees, unlike diversified investors, are significantly affected by bankruptcy.

(d) Thus, employees are biases against the firm making high risk investments.

(e) This leads to an agency cost where firms turn down investment is positive NPV projects.

(6) Another impact of the nondiversifiability of human capital on agency costs involves the firm's products and services.

(a) If the products and/or services are unique, the employee's human capital will have even less than normal diversification.

(b) Stockholders may have to pay such employees extra to compensate them for entering a profession that lacks other job alternatives.

(c) This agency cost of higher wages affects existing investments (whereas the agency cost from undiversified employees affect future investments).

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(1) Debt is risky because the contractually required payments to corporate debtholders may not be paid if stockholders exercise their default option.

(a) Incentive conflicts occur between the debtholders and the stockholders because the debt is risky.

(b) Whereas stockholders are principals with respect to their corporate managers, they are agents in their relationship with debtholders.

(c) The debtholders want to protect themselves against actions taken by the agent stockholders, who in turn made their decisions through the firm managers.

(2) With risky debt, stockholders may be motivated to substitute riskier assets for the firm's existing assets.

(a) This asset substitution problem occurs when riskier assets are substituted for the firm's existing assets, thereby expropriating value from the firm's debtholders.

(b) The asset substitution problem arises because the stockholders' put (default) option increases as the firm's assets become riskier.

(c) When a firm's assets are worth less than its debt obligations, the stock is like an out-for-the-money call option.

(d) By choosing a negative NPV (with a low probability of a big pay-off), managers may actually increase stockholder wealth but at debtholders' expense since they are putting up the money owed them due to their legal rights to payments.

(e) Even with risky investments that have a positive NPV, the stockholders may be the only party to profit.

(3) When stockholders profit at the expense of debtholders, then we have a situation where wealth has been transferred to stockholders. This is called a wealth transfer effect.

(4) Underinvestment is essentially the mirror image, or reverse, of the asset substitution problem.

(a) With risky debt outstanding, the stockholders may lose value if the firm makes a low-risk investment even if the investment has a positive NPV.

(b) With underinvestment, stockholders refuse to undertake a good (positive NPV), but low risk, since the financing of the project comes from shareholder wealth.

(c) For this risk shifting situation, the decrease in debtholder risk comes at the stockholders' expense.

(5) Paying out a large cash dividend may dilute the existing debtholders' claim.

(a) The dividend reduces the firm's cash and its stockholders' equity increasing the risk of the debtholders' claims.

(b) This is simply a different form of asset substitution. The substituted assets are the same except for having a smaller amount of a riskless asset (cash).

(6) Claim dilution via dividend policy is why many bond issues (and virtually all "junk," or high-yield, issues) have some form of dividend restriction.

(7) A substantial increase in debt may also dilute the existing debtholders' claim on the firm's assets.

(a) Claim dilution occurs if the new debt increases the chance that the existing debtholders will not be repaid the promised amount.

(b) As with asset substitution, the increased risk decreases the value of the firm's outstanding debt (this was seen with the leverage buyout of RJR Nabisco, Inc. in 1989).

(8) Firms with unique assets have assets that are less liquid. Thus, such firms will have more costly debt.

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(1) The consumer-firm interactions can be viewed as principal-agent relationship. In the first situation below, the firm is the agent; in the second situation, the firm is the principal.

(a) In its agent role, the firm promises future service, should it become necessary. If the consumer (principal) is confident that the firm will live up to its promise, the firm can get full value for its products and services.

(b) The potential for consumers (the agents in case) to duplicate and sell the firm's (the principal's) products and/or services without proper agreement is another example of the free-rider problem.

(i) Copying books, computer software, videotapes, and so on are examples.

(ii) Another free-rider problem area involves making and enforcing copyright, patent, and royalty laws that are important to international trade and relations.

(2) Firms can protect themselves from unscrupulous consumers (who exercise the hidden option to free-ride) by filing lawsuits.

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(1) Stockholders of financially distressed firms are better off engaging in asset substitution and underinvestment, taking the negative (and risky) NPV investment and leaving the positive (and safe) NPV investment.

(a) Stockholders have more to gain by getting bankers to keep the firm afloat because liquidation would give them very little if anything.

(b) The dramatic shift in incentives brought on by financial distress occurs because the contingent claim (the option) inherent in the situation falls in value and becomes out-of-the-money.

(2) A financial contract is complex because it involves imperfect information.

(3) Firms face the problem of adverse selection when an action signals a negative situation.

(4) Principals and agents with good reputations can profit from their reputation by demanding higher rewards or payoffs (and thus reducing the negative signaling stemming from adverse selection).

(5) Stockholders can help align their interests with managers through incentive compensation plans for managers, the right to sell their own shares, the right to replace managers, and the right to elect directors.

(a) Incentive compensation plans include management contracts that offer stock options, performance shares, and bonuses.

(b) If managers don't perform up to shareholder standards, then shareholders can sell their shares in large quantities putting downward pressure on the stock prices.

(i) Shares can be sold to a bidding company in a takeover.

(ii) The threat of a takeover is diminished by a "poison pill" measure that allows managers to sell shares below market if an unfriendly suitor is the bidding firm.

(c) Managers can be replaced if they get a poor job rating.

(d) Unhappy stockholders can elect new directors who will replace managers.

(6) Debt contracts are explicit legal contracts and called bond indentures.

(a) The structure of the contract affects the incentives by detailing responsibilities, constraints, punishments, and required monitoring.

(b) Such contracts specify the timing and amounts of all interest and principal payments.

(c) They appoint a particular agent, called the trustee, who has a legal responsibility to look after the bondholders' interests.

(7) Certain contractual provisions within a bond indenture are called bond covenants.

(a) These are designed to protect the interests of the bondholders.

(b) There are two types.

(i) A negative covenant limits certain actions, such as incurring more debt or paying dividends.

(ii) A positive covenant requires certain actions, such as regularly making tax payments and providing periodic financial statements.

(8) Bond covenants are a form of monitoring.

(a) They provide a warning system that is triggered when a firm fails to comply with a covenant.

(b) Bond covenants provide value by lowering the risk of the bonds.

(9) One alternative to an extensive array of restrictive bond covenants is the use of a conversion option to create a convertible bond.

(10) An optimal contract balances the three types of agency costs (contracting, monitoring, and misbehavior) against one another to minimize the total cost.

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(1) With an underwritten issue, the investment bankers provide a form of monitoring. They would not attempt to sell the new securities unless they thought the price was reasonable.

(2) Common monitoring devices include the following.

(a) Financial statements are audited accounting statements that can reveal current and future problems.

(b) Increasing cash dividends reveal information about earnings (and can lead to more frequent external financing).

(c) Bond ratings provide information about the firm.

(d) Others include bond covenants, government regulation, the entire legal system, reputation, and multilevel organizations can also provide forms of monitoring.

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(A1) In your own words, describe a principal-agent relationship. Cite two examples of explicit principal-agent relationships and two others that are not explicit but can be viewed as such.

A principal-agent relationship exists whenever one party (the agent) makes decisions which affect the other party (the principal). Explicit examples of principal-agent relationships include the lawyer-client and money manager-investor relationship. Implicit examples of principal-agent relationships include the stockholder-manager, debtholder-stockholder, and employer-employee relationships.

(A2) Describe and discuss the asset substitution problem.

The asset substitution problem occurs when one asset type is substituted for another asset type. For example, a firm with debt outstanding undertakes relatively high risk investments to increase the value of equity even though such investments reduces the value of debt (and may even reduce the overall market value of the firm). Because the debtholders are not compensated for the additional risk, the stockholders gain at the expense of the debtholders.

(A3) Describe and discuss the underinvestment problem.

The underinvestment problem occurs when a firm forgoes an investment because it increases the value of only one claimant. For example, with risky debt outstanding stockholders have the incentive to forego an investment that would increase the total market value of the firm but would only add value to debt. The positive NPV investment decreases the risk of the firm in such a way that only debtholders share in the increased total market value. For such an investment, stockholders would not want to put up any of their own funds.

(A4) Define the term moral hazard.

Moral hazard exists when the agent can take unobserved actions in the agent's own interest, to the detriment of the principal.

(A5) Define the term free-rider and explain why this phenomenon causes problems. Cite an example of the free-rider problem and a contract form that is typically used to reduce or eliminate the problem.

A free-rider is someone who receives the benefit of someone else's expenditure of money, effort, or creativity simply by imitation. The ability of people to free-ride on the efforts of another person reduces that player's incentive to expend the effort in the first place. An example of the free-rider problem is when others are able to copy and benefit from an inventor's valuable idea. Patent laws are the contract form that is typically used to reduce or eliminate this problem.

(A6) Define the concept of agency problems and cite three examples of such problems.

Agency problems occur when someone (an agent) is hired to act in the interests of another (the principal) and the agent can take actions in his own interest at the expense of the principal. Three examples of the agency problem are the asset substitution problem, the underinvestment problem, and the problem of claim dilution.

(A7) Cite three goals managers might have that are not necessarily consistent with the goal of maximizing shareholder wealth.

Three goals that managers might have that are not necessarily consistent with the goal of maximizing shareholder wealth are (1) maximizing growth (2) maximizing perquisite consumption, and (3) diversifying their specific human capital.

(A8) What is an agency cost? What are its three components? Cite an example of each one.

An agency cost is any cost involved in resolving principal-agent conflicts of financial self-interest. Agency costs are the incremental costs above what would be incurred in a perfect capital and labor market environment. The three components of agency costs are (1) financial contracting costs, e.g., incentive fees, (2) monitoring costs, e.g., auditing costs, and (3) misbehavior costs (the loss of wealth the principal suffers as a result of the agent's pursuing divergent goals with an imperfect contract) for example the cost of elaborate offices. Agency costs are borne entirely by the principal.

(A9) Cite and describe two way in which the uniqueness of assets creates agency costs for shareholders.

Asset uniqueness creates agency costs for shareholders in two ways: (1) There is greater risk associated with the disposal of unique assets so they have lower collateral value. This causes the debtholders to require a higher interest rate to compensate them for the increased risk associated with such assets. (2) When the firm's assets are unique, its employees human capital will be even less well-diversified. This causes the employees to require higher pay.

(A10) How can employee perquisites create a conflict between the shareholders and the employees?

Employee perquisites create a conflict between the shareholders and the employees because they provide personal benefit to the employees but reduce the stockholders' residual claim on the earnings of the firm.

(A11) How can product and service guarantees create an agency problem between the firm and its consumes?

Product and service guarantees can create an agency problem between the firm and its consumers because the consumers will only pay the firm "full value" for its products and services if they believe that the firm will fulfill its promise of future service.

(A12). Cite and briefly discuss four devices that naturally monitor agent behavior for the principal.

Four devices that naturally monitor agent behavior for the principal are described below. First, the shareholder's right to elect the directors acts to monitor manager behavior. The mere threat that they can act on their dissatisfaction with managerial behavior through electing new directors serves to make managers behave properly. Second, incentive compensation plans that make the manager's compensation depends on the firm's performance. This aligns the manager's goals with those of shareholders. Third, the shareholder's right to sell their shares acts to monitor managers' actions. For example, the ability to sell shares to prospective acquirers in a takeover attempt acts to control managerial behavior. Fourth, competition in the managerial labor market causes the manager to act in ways that improve the firm's performance. Managers desire to achieve a good reputation and not be fire for poor job performance.

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