Question

1.Describe the capital structure decision making process in the context of agency costs, and contrast this with the M&M theory.

2.A bond has a covenant that prohibits the company from changing its line of business. What is the rationale for this type of covenant, in the context of the issues we have discussed this quarter?

Answer 1

Greetings,

1. Agency Costs are the costs incurred by the company arising out of conflict of interest between common shareholders and management of the company . Agency costs include -

• Salary and Perks of the management known as direct costs. There costs will be incurred irrespective of the choice of capital structure.
• Indirect costs ie costs arising due to conflict of interest ie management may engage in those activities which may not be beneficial for common shareholders but beneficial for them like excessive use of inorganic growth avenues (merger and acquisitions) to become big and big but such merger may not be in the best of the interests of the company.

So choice of equity over debt will increase the agency costs. While if there is debt in the company then agency costs come down due to following reasons -

• Debt brings in the risk of bankruptcy ie chances that another company may acquire us at penny prices increases. It is because debt holders have many rights when a particular covenant gets triggered. So if the management performed poorly, then they may exercise many such rights and create distress.
• After servicing interest payments, company is left with little cash flows as compared to all equity financed firm. So management becomes disciplined as they do not have the funds to live lavishly like corporate jets, foreign travels etc at the expense of the company.

So agency costs favour debt funding.

MM Theory with taxes also advocate the use of debt. It says that since the debt interest is tax deductible, so firm should use more and more debt as the cost of capital of firm falls as debt is increased. So value of levered firm = value of unleveled firm + tax shield on debt.

In essence, both the theories advocate the use of debt.

2. Such a covenants are known as restrictive covenants. If a company goes into another business without the consent of the debt holders then it may happen that business is more riskier than the existing business and eventually company may become bankrupt. Equity holders are not worried as they have limited liability. They see share as a call option. They have upside potential but on downside maximum loss is the cost of shares which they paid. Debtholders had lent money considering risk of the original line of business. Now if the company goes into more risky business, so the required return rise and the price of bonds fall. So they lose.