Corporate Financial Management chapter 14 Agency theory solution
Chapter 14
Questions
1.
A principal-agent relationship is a relationship where an agent makes decisions that affect the principal. Examples of explicit principal-agent relationships are the relationships between a client and a lawyer and between an investor and a money manager. Examples of implicit principal-agent relationships are an employee acting on behalf of its employer and a consumer making decisions, such as copying and selling a product, that can affect a manufacturer.
2.
The asset substitution problem occurs when riskier assets are substituted for the firm’s exisiting assets. This problem can occur because the shareholders have the option to default on debt. In essence, the shareholders can gamble with the debtholders’ money by substituting existing assets for high risk assets. Debtholders are not compensated for the additional risk, and the stockholders gain at the expense of the debtholders. If the risky assets result in a large payoff, the shareholders benefit because the debtholders’ payments are fixed. If the risky assets fail, the debtholders will lose their investment. Because of the potential for shareholders to gain at the risk of the debtholders, asset substitution results in an expropriation of wealth from debtholders to stockholders.
3.
The underinvestment problem is essentially the mirror image of the asset substitution problem. With underinvestment, stockholders refuse to undertake a good (positive-NPV), but low-risk, investment because if they made the investment it would shift wealth to the debtholders at the stockholders’ expense. The wealth shift would be caused by increasing the chances that the debtholders will be fully repaid (i.e., the low-risk investment would reduce the chance of bankruptcy).
This occurs whenever a low-risk investment’s positive NPV is not large enough to overcome the wealth shift from stockholders to debtholders that would come with the investment.
4.
A moral hazard is an
Questions
1.
A principal-agent relationship is a relationship where an agent makes decisions that affect the principal. Examples of explicit principal-agent relationships are the relationships between a client and a lawyer and between an investor and a money manager. Examples of implicit principal-agent relationships are an employee acting on behalf of its employer and a consumer making decisions, such as copying and selling a product, that can affect a manufacturer.
2.
The asset substitution problem occurs when riskier assets are substituted for the firm’s exisiting assets. This problem can occur because the shareholders have the option to default on debt. In essence, the shareholders can gamble with the debtholders’ money by substituting existing assets for high risk assets. Debtholders are not compensated for the additional risk, and the stockholders gain at the expense of the debtholders. If the risky assets result in a large payoff, the shareholders benefit because the debtholders’ payments are fixed. If the risky assets fail, the debtholders will lose their investment. Because of the potential for shareholders to gain at the risk of the debtholders, asset substitution results in an expropriation of wealth from debtholders to stockholders.
3.
The underinvestment problem is essentially the mirror image of the asset substitution problem. With underinvestment, stockholders refuse to undertake a good (positive-NPV), but low-risk, investment because if they made the investment it would shift wealth to the debtholders at the stockholders’ expense. The wealth shift would be caused by increasing the chances that the debtholders will be fully repaid (i.e., the low-risk investment would reduce the chance of bankruptcy).
This occurs whenever a low-risk investment’s positive NPV is not large enough to overcome the wealth shift from stockholders to debtholders that would come with the investment.
4.
A moral hazard is an