The Impact of Two Agency Problems on the Cost of Capital
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, tyang1@nchu.edu.tw. 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
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, tyang1@nchu.edu.tw. 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