1. What are agency costs, and how are agency costs of financial distress different from agency benefits of leverage? Explain their impact on calculating the value of a firm with financial distress.
Answers
What are Agency Costs?
Agency costs are internal costs incurred due to the competing interests of shareholders (principals) and the management team (agents). Expenses that are associated with resolving this disagreement and managing the relationship are referred to as agency costs.
Agency Costs
The key takeaway point is that these costs arise from separation of ownership and control. Shareholders want to maximize shareholder value while management sometimes makes decisions that are not in the best interest of shareholders (i.e., those that benefit themselves).
For example, agency costs are incurred when the senior management team, when traveling, unnecessarily books the most expensive hotel or orders unnecessary hotel upgrades. The cost of such actions increases the operating cost of the company while providing no added benefit or value to shareholders.
Agency costs fall into 2 categories:
Costs incurred when the agent (management team) uses the company’s resources for his or her own benefit.
Costs incurred by the principal (shareholders) to prevent the agent (management team) from prioritizing him/herself over shareholder interests.
Direct and Indirect Agency Costs
Agency costs are subdivided into direct and indirect agency costs.
There are two types of direct agency costs:
Corporate expenditures that benefit the management team at the expense of shareholders
An expense that arises from monitoring management actions to keep the principal-agent relationship aligned.
The first type of direct agency costs is illustrated above, where the management team unnecessarily books the most expensive hotel or orders unnecessary hotel upgrades that do not add value or benefits to shareholders.
An example of the second type of direct agency cost is paying external auditors to assess the accuracy of the company’s financial statements.
Indirect agency costs refer to lost opportunity. Say, for example, shareholders want to undertake a project that will increase stock value. However, the management team is afraid that things might turn out badly, which might result in the termination of their jobs. If management does not take on this project, shareholders lose a potentially valuable opportunity. This becomes an indirect agency cost because it arises out of the shareholder/management conflict but does not have a directly quantifiable value.
Agency Cost of Debt
Agency cost of debt is the increase in the cost of debt or the implementation of covenants for fear of agency cost problems. Debt financiers in a company are not in control of their money – the management is. Agency cost of debt generally happens when debt holders are afraid the management team may engage in risky actions that benefit shareholders more than bondholders. For fear of potential principal-agent problems in the company, debt suppliers may place constraints (such as debt covenants) on how their money is used.
The Principal-Agent Relationship
The principal-agent relationship plays a major role in agency costs. The principal-agent relationship is an arrangement between two parties in which one party (the principal) legally appoints the other party (the agent) to act on its behalf.
The principal-agent problem occurs when the interests of the principal and agent are not aligned. As a result, agency costs are incurred.
To identify a potential principal-agent problem, consider the following example:
You hire the services of a roofer to fix your leaking roof. The hourly wage that you pay to the roofer is $40. A principal-agent problem can arise as the interest of the roofer may not be the same as yours. The roofer, knowing that he is paid hourly, may try to take as much time as possible to fix the roof so he can make more money. You are unable to prevent this, as you know very little about repairing roofs. The agency cost is the extra amount you pay the roofer to get the roof fixed.
Reducing Agency Costs
The most common way of reducing agency costs in a principal-agent relationship is to implement an incentives scheme. There are two types of incentives: financial and non-financial.