Question

Why use of debt can minimize the agency cost (500words)

Explain why company issue equity (300 words)

Thank You

Answer 1

Ans 1) The use of debt impacts agency cost in several ways. First, the use of debt reduces the free cash flow available to managers, as promised interest payments to debt holders decrease free cash flow available for investment. This decrease in free cash flow also helps in curtailing overinvestment problem.Second, use of debt can increase monitoring of managers by debt holders like bank, which put pressure on managers to run business profitable.Third, by increasing the threat of bankruptcy because in case of bankruptcy managers will lose benefits which they get form firm. Free cash flow is the excess of cash that is required to fund all positive NPV projects. Managers have discretion to use free cash flow and this creates potential agency conflict. Managers can use free cash flow for enjoying perquisites or invest this free cash flow to increase resources under their control for empire building. This empire building would allow managers to create higher salaries and would offer greater power to them. This investment by managers creates overinvestment problem. Overinvestment refers to a situation in which managers invest in too many projects even when projects don’t benefit shareholders. This conflict created by free cash flow can be controlled by using debt in capital structure. By issuing debt, the managers of firm are obliged to make periodic payments of interests and principal. These periodic payments reduce amount of free cash flow available for use by managers and hence reduces agency conflict between owner and managers.

The use of debt also increases monitoring of managers’ activities. As creditors have incentive to monitor to performance of the enterprise to ensure the payment of interest and principal. Banks, which are the major source of financing, play very important role in optimizing the monitoring of managers. Large debt holders also have contractual right to monitor activities of manager. This monitoring by creditors also helps owners in monitoring managers and reduces cost of monitoring managers by owners. The other effect which is created by debt is the threat of bankruptcy. The threat of bankruptcy forces managers to run business in profitable manner. The creditors have legal right to take a firm to court if it fails to honor the claims of creditors. This creates threat for managers of losing their jobs in the event of liquidation of the firm. The threat of losing jobs put pressure on managers to run business profitably and stops them from exploiting the resources of business. The use of debt limits the tendency of managers to use firm’s resources inefficiently. In this way debt helps in disciplining manager and forces them to purse business value maximizing goals. In summary the use of debt helps in reducing agency cost in many ways and this reduction on agency cost leads to overall higher firm value.

Ans 2) why companies issue equity shares

Companies looking to expand their business may decide to finance the endeavor by taking the company public and issuing stock. Private markets may not offer the kind of financing or amount of financing a company needs in order to grow, so registering as a publicly traded company and having an initial public offering (IPO) can simplify the process and raise capital quickly. Although issuing stock is a popular way a company can raise money, there are significant downsides to doing so.

Providing Liquidity

When the founder or investors of a private company want to sell and take part of their profit out, the have to get their portion valued and find a buyer willing to buy at that price; a time-consuming and often unrealistic proposal. By issuing stock and making the company public, the company is broken down into highly liquid and tradeable stocks that can be easily redeemed. It gives private investors a way to take profits and is often the end goal of many start-up companies.

Downside

The biggest downside to issuing stock and taking a company public is the loss of control given up to investors. Regulations create an ongoing expense as well, necessitating a watchful eye of accounting practices. Limits imposed on publicly traded companies can also create hardship when it comes to investments and capital expenditures.

Conclusion

A company issues stock only when large amounts of capital are needed. The company may need an infusion to finance to purchase of new equipment, buy property, or hire workers. Private investors often require a bailout policy to take the company public which will return value to them as well. In short, issuing stock is a method of capital raising usually used only in circumstances of growth or liquidation.