Question

Jensen and Meckling (1976) also provide potentially important insights into the choice of Capital Structure.

They discuss Agency Conflicts and the Costs associated with these. Describe the Agency Conflicts between Corporate Managers and the Stockholders of the firm. Next, describe the Agency Conflicts between the Bondholders and Stockholders of a firm. Be sure to carefully explain how the level of debt in capital structure will affect both types of agency conflicts. Describe how the trade-offs between the different classes of Agency Conflicts and the associated Costs may produce an Optimal Capital Structure in Jensen and Mecklings’ framework. Carefully, explain Michael Jensen’s notions of what types of firms should employ high levels of debt, and which should not. Describe the “Under Investment Incentive” that Stewart Myers outlined in “Determinants of Corporate Borrowing” (1977). What is the source of this incentive? What is a sinking fund, and describe how such an arrangement would reduce the Under Investment Incentive?

Please describe in great detail to what is being asked.

Answer 1

The Agency Conflict between corporate managers and stockholders of the firm is that managers are supposed to take decisions that maximize the wealth of shareholders even though the manager would want to take decisions that are in his own best interest and maximize his own wealth. The ownership and control is in different hands in a business. The ownership is held by stockholders whereas control is in the hands of the managers. This separation between ownership and control leads to agency conflict.

The Agency Conflict between bondholders and stockholders: Stockholders have the ownership of the organization whereas bondholders are the creditors. Stockholders and bondholders have different objectives. Stockholders would have an incentive to take up riskier projects whereas bondholders would be risk-averse. Stockholders objective is maximization of their wealth whereas bondholders primary objective is to get their investment back. Stockholders would want that the organization pays out more dividends but bondholders may not want so.

Since managers, stockholders and bondholders all have different objectives, there is a high probability that principal-agent problems exist. So, the bondholders (creditors) increase the cost of debt when a managerial hubris arises.

Agency conflict between managers and stockholders: By increasing the debt, companies shall pay interest and cash flow will decrease. Therefore, less liquidity is there in hands of managers to engage in activities that impact wealth maximization for shareholders.

Agency conflict between bondholders and stockholders: Optimal capital structure can be attained by finding a point where the total agency cost is least as shown in the figure below. Agency costs can be minimized by charging higher rates of interest if the bondholders can predict that the shareholders might engage in riskier projects.

Underinvestment Incentive: The problem of underinvestment occurs between stockholders and bondholders where a company will forego investment opportunity because benefits will pass onto the bondholders and bondholders would benefit more than the stockholders. The company has no incentive to invest in low-risk projects adhering to the bondholders. Rather the company would want to placate its shareholders by investing in riskier projects that might yield higher returns but expose bondholders to a larger risk.

A sinking fund is a way of paying back the amount borrowed through a bond via payments made periodically to a trustee who retires the issue partly by buying bonds in the open market. It means repaying a part of the bond each year until the whole debt is fully repaid.