Firms are formed by individuals with an aim of providing a certain product or service to consumers. In order to be able to deliver on its mandate, the firm requires real assets to carry on its business. At first, the founders of the firm will provide the necessary finances required to organize the firm’s activities and will directly be involved in the running of the business. The capital provided by the founders and owners is referred to as equity capital (equity financing). Individual will start a venture or firm to earn a return on their investment and therefore increase their wealth. As such, the major objective of the firm will therefore be the maximization of the wealth of the owners of the firm.
The business enterprise will eventually grow and become big and therefore the owners might not have time or the expertise to run organizations of such a magnitude. In essence, the owners will hire professional managers to manage the firm on their behalf. As such, the managers become representatives of the owners at the company, i.e. agents with the owners taking the position of the principal. Thus there is a principle-agent relationship between the managers and the shareholders. On the other hand, the expansion of the firm brings about increased need for funds to finance growing demand and expansion. The shareholders on their own might not be able to raise the required funds to meet the firm needs. At the same time, equity finance is relatively expensive as compared to other sources of finance as it is exposed to the firms operating risks. Therefore the firm might seek to finance part of its operations from secured sources of capital which creates an obligation to pay the amount borrowed plus a fixed amount of income on the amount borrowed for a specific period of time (Pandey, 2004). Since the lenders will provide capital funds to the firm with the promise that their interest will be secured by a charge on the assets of the company, and the company promises a fixed annual income, its expected that the management of the company will ensure that the asset pledged are secured and proper levels of liquidity are maintained to ensure that the income on money advanced to the firm is duly paid to the lenders. Therefore, a principal-agent relationship exists between the lenders and the managers (Pandey, 2004).
While it is explicit that the various sources of long-term finances create various agency relationships within the firm, the continued adherence to the agency duties and responsibilities is not guaranteed. An agency relationship requires that the agent acts in the best interest of the principal. However, the agents might not have the same interests as their principals and if left on their own will work for their own interest but not for the interest of the principal. It therefore becomes imperative for the principal to put in place measures to monitor the acts of the agents. The monitoring process gives rise to a number of costs commonly referred to as the agency costs. The agency costs might also include the failure to achieve optimal shareholders’ wealth maximization. It has been argued out that agency costs can be reduced by employing debt in the firm’s capital structure. The question is how practical is this supposition?
A firm decides which way to finance its capital projects. The capital structure is the mix of debt and equity capital a firm employs in financing its capital projects (加参考书). The company can elect to increase the owners’ claims on the assets of the company or the creditors’ claims on the assets of the company. The capital structure decision is a very significant managerial decision which affects the risk and return on the shareholders funds. In most cases, companies are expected to plan their capital structures during their preparation for incorporation (promotion). However, firms will also make capital structure decisions when raising funds to finance an investment. The decision will involve an analysis of the existing capital structure and factors that might affect the present decision.
The mix between debt and equity in the capital structure has an implication on the risk and return of the shareholders, and therefore eventually affects the cost of capital and the market value of the firm. In essence, the management of a firm is faced by the decision of determining the proportions of debt and equity in the capital structure. Debt financing binds the company legally to pay the principal and interest on the amount borrowed as they fall due. Debt financing is fixed charge source of funds and its use in the capital structure is referred to as financial leverage. Leverage is the ability of gaining advantage through help. In essence, the firm is able to benefit from funds provided by lenders since the interest charged on debt is taxed deductable hence has a potential of increasing the earnings attributed to the ordinary shareholders. The return on shareholders’ equity will be levered above rate of return on total assets if the after tax cost of debt is less than the return on investment. This is one of the most observed merits of using debt financing in a firms capital structure.
In addition, the suppliers of debt have limited participation in the company’s business and profits and therefore will insist on protections in earnings and in values represented by ownership equity. Debt financing is majorly sourced through the issue of various instruments, depending on whether it is short-term or long-term. For short-term purposes, the company might issue commercial papers, certificates of deposit, or bills of exchange. On the other hand the company might issue bond indentures, debentures and mortgage certificates in order to raise long-term capital funds. These items are legal documents with binding provisions which the company must adhere to during the life of the debt instrument. The instruments create legal obligations which the management has no other alternative but to meet the obligations even if they conflict with their managerial interest at that particular point. Any failure to meet the obligations as spelled out in the debt instruments exposes the firm to the risk of bankruptcy
The firm is made up of many stakeholders who have particular sets of associations found around the operations and objectives of the firms. For instance, a firm is made up of shareholders who are the owners of the firm, creditors or lenders who are the debt holders (outsiders who have a claim on the assets of the firm by virtue of the amounts they contribute) but are not owners, the regulatory authorities like the tax authorities and government, customers, among other stakeholders (Brigham and Daves 2009, p. 9). An agency relationship arises whenever an individual called the principal, hires someone else, called an agent, who performs some duties that are delegated to him by the principal. For the case of the firm, the primary agency relationships are usually established between shareholders and management; and between shareholders and debt holders.
Ideally, managers are given mandate by the shareholders of the firm to make decisions that affect the operations of the entity, with the hope that the decisions will be made with the hope of maximizing the wealth of the owners. An agency problem might arise in the event that managers do have their own interest and might choose to pursue them at the expense of the shareholders interest (Brigham and Daves 2009, p. 9). If the firm is managed by its owners, the firm will be run with an objective of maximizing the welfare of its owners. The welfare of the owners is presumably measured in terms of increase in the wealth, more leisure or more perquisites for the shareholders. In the event that the proprietor decides to incorporate the firm and sell part of it to external investors a potential conflict of interest arises. The owner/manager might decide to work less strenuously, take more perquisites or might increase his salary. Since the managers own only a small percentage of the firm the objective of shareholders wealth maximization may take a backseat to management personal goals. Managers might pursue huge executive compensation schemes of could strive to maximize the size of the firm (empire building), as opposed to the wealth of the shareholders. All these management pursuits are in direct conflict with the overall objective of the firm which is shareholders wealth maximization.
In an attempt to encourage managers to act in the interest of shareholders, the shareholders use a raft of measures such as incentives, constraints and punishments (Burkart and Panunzi, 2005). These measures lead to the incurrence of agency costs by the shareholders which include all costs borne in encouraging managers to pursue wealth maximization as the primary goal of the firm. It’s vital that the firm incur the cost associated with agency relationship so as to arrest the possible effect of the agency conflict which could mean that the firm winds up altogether. The firm will in most cases incur three major agency costs, i.e. expenditure to monitor managerial action (auditing costs), costs associated with limiting undesirable managerial action through appointment of an independent board or directors, and opportunity cost of the lost opportunity resulting from restrictions on managerial decision making. As earlier observed, shareholders risk loosing their entire wealth if they fail to make any effort to affect managerial behaviour, which will most probably be self-dealing. On the other hand, agency costs would be exceedingly high if shareholders attempt o ensure that every managerial action coincides exactly with shareholders interest. It has been argued out that if the firm managers are compensated solely based on the long-term price of the firm stock, then the expected agency costs would be low since managers would have a huge incentive by maximizing the wealth of the shareholders.
The use of debt financing in the capital structure has been cited as one of the method that can drastically reduce the expected agency costs. Debt instruments are accompanied by a number of legally binding documents whose provisions must be observed by the management of the company. The commonly used debt documentations are the bond indenture and covenant. The two documents have a raft of conditions that must be met during the life of the debt instrument. They state the required minimum levels of firm liquidity, profitability, asset management, future investments, future financing and managerial behaviour. These measures ensure that management makes decisions that add value to the firms bottom-line, hence securing their investment. Failure to adhere to these requirements has the potential of leading the firm into bankruptcy meaning that the managers loose their jobs. In essence, management will strive as much as possible to make decisions that maximize the welfare of the stakeholders hence negating the need to put in place costly strict compliant measures (Albuquerque and Wang 2005).
A relationship subsists within the firm between the shareholders (agents) and creditor (principals). The creditors have a claim on the earning stream and the assets of the firm in the event of bankruptcy. On the other hand, shareholders have control over the firm through their agents the managers and take decisions that affect the riskiness of the firm. Creditors will advance funds to the firm at rates that are reflective of the risk of the firm at the time of transaction. The lending decision is entirely based on the riskiness of the firm’s existing assets; the expected risk of the firm’s future assets; the existing firm’s capital structure; and expectations of future capital structure changes. The expectation by the creditors is that the company will not make decisions that increase the riskiness of the firm after the credit transaction has been completed (Adair, 2011). The shareholders are the owners of the company and through their oversight roles should ensure that managers do not make decisions that threaten the funds contributed by creditor. However, shareholders might approve projects which by virtue of them being profitable increases their wealth but raises the risk profile of the firm. Such decisions create a conflict of interest between the shareholders and creditors. Shareholders are interested in the project return while the creditors are only interested in the risk of the project. At the center of the conflict is the fact that for any risky project taken by the firm, the shareholders are bound to benefit a lot if all goes well as such projects attracts much bigger returns. The creditors will not in any way benefit from the projects since their share in the earnings of the firm are fixed when the credit transaction is completed. However, if the project goes wrong, the creditors are bound to be negatively affected since the higher risk increases the expected cost of debt hence reducing the value of the debt held by the creditors of the company.
The question has been whether the shareholders should, through their managers, take advantage of the creditor by approving risky projects? It is not good business practice for the firm to deal with the creditors unfairly. Unethical behaviour is against best practices in business and if creditors perceive that the firm’s managers are trying to treat them unfairly, they might refuse to enter into any further dealings with the firm or might only lend to the company at a higher cost. Increased cost of credit is detrimental to the shareholders in the long-term (Adair, 2011). In essence, the major indirect agency cost arising from the conflict between shareholders and creditors is the higher cost of capital the firm will have to content with in such a situation. However, the debt financing has inborn measures that attempt to reduce the potential of the firm engaging in unfair practices against the creditor and therefore effectively reduce the expected cost of agency relationship between the shareholders and creditors. The creditors attempt to protect themselves from such actions by including restrictive covenants in the debt agreements. Restrictive covenants put a limit to the extent of management decision relating to new debt financing, capital structure decisions, investments decisions, assets management and working capital decisions. The covenant might restrict adoption of risky projects, payment of cash dividends and taking of additional borrowings. Constraints and sanctions within debt instruments, management actions that would be detrimental to the wealth of shareholders and the welfare of other stakeholders like customers, the community, suppliers and employee is effectively curtailed and therefore reduces the need to institute strict monitoring measures by the shareholders (Brigham and Daves 2009, p.15). Debt financing is therefore an essential factor in reducing the expected cost of agency conflict.
Debt financing is an alternative source of capital to equity finance in providing long-term finances. Debt instruments have legally binding agreements which govern management behaviour during the life of the debt instruments. By use of restrictive covenants and bond indentures, management behaviour is limited to stakeholder welfare maximization. Violation of these provisions puts the firm at risk of bankruptcy and therefore management will strive to uphold them. In essence, debt financing reduces the need by shareholders to monitor management actions since the inherent debt agreements which do not need extra costs serve the same purpose.
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Adair, T 2011, Corporate Finance Demystified, New York: McGraw-Hill
Albuquerque, R and Wang, N 2005, ‘Agency Conflict, Investments and Asset Pricing’, [Online] Available at <www.nyu.edu/econ/user/galed/fewpapers/FEW F06/Albuquerque-Wang.pdf> Accessed on 24th March, 2011
Brigham, E.F and Daves, P. R 2009, Intermediate Financial Management, New Jersey: Cengage Learning
Burkart, M and Panunzi, F 2005, ‘Agency Conflict, Ownership Concentration, and Legal Shareholder Protection’, Journal of Financial Intermediaries, Vol. 15, pp. 1-3, [Online] Available at <www.elsevier.com/wps/find/journaldescription.cws_home/622875/description#description> Accessed on 24th March, 2011
Pandey, I.M 2004, Financial Management, New Delhi: Vikas