Question

•What are the possible conflicts of interest between a shareholder and a debt holder?

•How can free cash flow reduce the conflict of interest between managers and shareholders?

•What is the relation between firm life cycle and capital structure?

Answer 1

Q. What are the possible conflicts of interest between a shareholder and a debt holder?

A. Generally, conflict between shareholders and bondholders takes place because stockholders benefit from corporate gambles, while bondholders benefit from playing it safe. Because management is the shareholders' agent, corporations often do what the shareholders want. Stockholders have an incentive to take riskier projects than bondholders do. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point. Bondholders may put contracts in place prohibiting management from taking on very risky projects or may raise the interest rate demanded, increasing the cost of capital for the company. Conversely, shareholder preferences--for example for riskier growth strategies--can adversely impact bondholders. Other conflicts of interest can stem from the fact that bonds often have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely but can also be sold at any point.

Q. How can free cash flow reduce the conflict of interest between managers and shareholders?

A. Free cash flow (FCF) is considered as one source of conflict between managers and shareholders. Managers of firms with high FCF and of low growth opportunity tend to invest in marginal or even negative NPV project and use income increasing discretionary accruals to camouflage the effects of non-wealth-maximizing investments. Earnings and book value are value relevant and agency problem caused by FCF, reduces the value relevance of earnings and book value. However, the effect is not stable across sample years Firms with FCF agency problem do not have lower earnings (book value) coefficient than other firms. In Free Cash Flow theory, debt may play an important role in reducing the agency costs. Debt holders have no voice in the operations of the company unless the debt needs renewing, or the firm fails to meet the contract. Still, debt is a strong form of commitment: it is a contract that might include a collateral, and constrains managers to meet payment terms. Managers are thus forced to make wise investments.

Q. What is the relation between firm life cycle and capital structure?

A. Capital structure decisions varies in the lens of the business life cycle. One needs to look at capital structure decisions which are based on a failure to take into account the different degrees of information opacity, and, consequently, firms' characteristics and needs at specific stages of their life cycles. E.g. in a bank-oriented country, firms tend to adopt specific financing strategies and a different hierarchy of financial decision-making as they progress through the phases of their business life cycle. Contrary to conventional wisdom, debt is shown to be fundamental to business activities in the early stages, representing the first choice. By contrast, in the maturity stage, firms re-balance their capital structure, gradually substituting debt for internal capital, and for firms that have consolidated their business, the pecking-order theory shows a high degree of application. This financial life-cycle pattern seems to be homogeneous for different industries and consistent over time.