The Impact of Two Agency Problems on the Cost of Capital

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The Impact of two agency problems on the cost of capital

Tung-Hsiao Yang*

Current Version: September 10, 2008


Assistant Professor of Finance, National Chung Hsing University, Department of Finance, No. 250, Kuo Kuang Rd., Taichung 40227, Taiwan, The author thanks National Science Council for financial support in this project, NSC96-2416-H-005-026.

The Impact of two agency problems on the cost of capital

Abstract We test the relation between the cost of capital and two agency problems, free cash flows and overinvestment in this paper. The empirical results show that both agency problems have significantly positive impact on the cost of capital. In addition, the incentives from stock-based compensation also have significant positive influence on the cost of capital. After taking the incentives into account, we find that the significance of the positive impact from the agency problems disappears. Therefore, we conclude that the incentive effects dominate the agency problems in determining the cost of capital. Well-designed executive compensation can mitigate both agency problems.

1. Introduction The principal-agent relationship has several potential problems in corporate management that so-called agency problems. Due to the conflict of interests between shareholders and managers, shareholders need to pay substantial costs to alleviate these problems, such as monitoring costs or handsome executive compensation to provide incentives for managers to create firm value. In addition, these problems usually result in firm’ poor performance, either market or accounting performance. From s fundamental valuation theories, firm market value is affected by the firm’ free cash s flows and its cost of capital. 1 In this project, we focus on the issue whether agency problems can affect the firm’ cost of capital. That is whether m ngr s aae sdecisions ’ could have impact on the firm’financing cost. s High corporate cash holdings and overinvestment are two main agency problems in the agency theories. From existing empirical evidence, there is a positive relation between these two agency problems. That is, overinvestment usually occurs in firms with high free cash flows (see Richardson (2006)). Corporate cash holdings itself, however, provide an opportunity for managers to generate their own private benefit. Therefore, we focus on these two types of agency problems in this paper. Because these two problems can change the firm’risk level from the market perspective, under s the assumption of efficient market hypothesis the financial market should take these factors into account and reflect their changes into the fm s i ni cs Based on i ’ f ac g ot r n n . this hypothesis, we expect to observe the positive impact of agency problems on firm’ s cost of capital. The managerial incentives from executive compensation have substantial impact on agency problems. Aggarwal and Samwick (2006) show that both Tobin’ Q and s investment increase with the pay-for-performance sensitivity from stock and stock option compensation.2 This result implies that managers would increase the investment when they have more stock-based compensation. Broussard, Buchenroth, and Pilotte 1

In this project, we only focus on the cost of equity instead of overall cost of capital. However, we use cost of capital and cost of equity interchangeably in the context. 2 There is another implication in earlier research in contrast to Aggarwal and Samwick (2006). Mizjak, Brickley and Coles (1993) suggest that executive compensation contracts depend on the level of information asymmetry in each firm. They use traditional measures of growth opportunity, market-to-book ratio and R&D expenditures, as proxies for information asymmetry.


(2004) find evidence that incentives can reduce the overinvestment problem. Therefore, based on these results, we are interested in two questions about the effect of stockbased compensation on agency...
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