Agency Theory

Principal-Agent
The Firm
Principal [Uninformed]
Agent [Informed]
1. Moral hazard with hidden action
2. Moral hazard with post-contractual hidden
knowledge
3. Adverse selection
4. Signalling
5. Screening
Moral Hazard: Managers
1. Reputation
2. Risk-sharing contracts
3. Boiling in oil
4. Selling the store-LBO
5. Efficiency wages [higher]
6. Tournaments
7. Monitoring
8. Repetition [rainbow]
9. Changing type of agent
Adverse Selection:
Managers
1. Quality certification
2. Testing
3.Reputation
4. Social customs

Theory of the firm [Public
company]
Firm characterized by contract and not fiat
Joint input production, several input owners
How to ensure monitoring?
Appoint a Peak monitor
Contracts with all input owners
Residual claimant
Right to sell contractual residual status


Agency Theory: The Firm
Legal fiction that serves as a nexus for
contracting relationships
Divisible residual claims on assets and cash
flows that can be sold without permission of
other contracting individuals
Agency Costs
Principal and agent divergent interests
Principal can monitor
Agent can bond
Residual loss
Agency Theory: Conflicts
Outside Shareholder-Owner Manager
Bondholder-Shareholder
New Shareholder-Old Shareholder
Outside Shareholder-Owner
Manager
100% owner trades off Firm Value V* and
Value of On-the-job non-pecuniary
perquisites
What happens if claim is diluted to ?
Outsider will be willing to pay (1- ) V
Monitoring and bonding influence V
Outside Shareholder-Owner
Manager: Free Cash Flow Problem
For this purpose we will define Free Cash Flow as cash
flow in excess of positive NPV project needs
Acquiring-firm shareholders lost 12 cents around
acquisition announcements per dollar spent on acquisitions
in 1998-2001
Aggregate loss $240 billion
87 acquisitions lost more than 1 billion dollars each
These also lost $2.31 for every dollar spent on acquisition
Shareholders would have been better off if managers had
simply burnt cash/shares used for acquisition
Bondholder-Stockholder
Conflicts
Asset substitution
Under-investment
Short-sighted investment
Liquidation:
Single class of lenders
Multiple classes of lenders

BONDHOLDER-STOCKHOLDER CONFLICT
1. ASSET SUBSTITUTION
[INCENTIVE TO TAKE HIGHER RISKS]
INVEST 8000 AT YEAR 0 IN 1-YEAR PROJECT
LOAN OUTFLOW OF 7000 IN YEAR 1
STATE PROB. PROJECT1 PROJECT2
GOOD 0.5 11000 18000
BAD 0.5 9000 2000
EXP. VALUE 10000 10000
PROJECT 2 HAS SAME SYSTEMATIC RISK AS 1
PROJECT1 PROJECT2
LENDER PAYOFF
GOOD 7000 7000
BAD 7000 2000
EXP. 7000 4500
EQUITY PAYOFF
GOOD 4000 11000
BAD 2000 0
EXP. 3000 5500
BONDHOLDER-STOCKHOLDER CONFLICT
2. UNDERINVESTMENT
EQUITY DISC RATE/INT RATE ZERO
NPV 0 1 2
100 A -50 100 50
25 B -75 100
A. ALL EQUITY FIRM
WILL ACCEPT BOTH
B. FIRM WITH DEBT OUTSTANDING
1 2
DEBT -20 -100
PAYOFF A+B
EQUITY 5 50
DEBT 20 100
B. FIRM WITH DEBT OUTSTANDING
1 2
DEBT -20 -100
PAYOFF A
EQUITY 80 0
DEBT 20 50
BONDHOLDER-STOCKHOLDER CONFLICT
3. SHORTSIGHTED INVESTMENT
EQUITY DISC RATE/INT RATE ZERO
1 2
DEBT -100 -40
EXISTING ASSETS
GOOD 50 60
BAD 50 10
ST PROJ 50 0
LT PROJ 20 40
ST PROJ EQUITY VALUE
GOOD 20
BAD 0
LT PROJ EQUITY VALUE
GOOD 10
BAD 0
WITH LT PROJECT, SUBORDINATE NEW DEBT
OF 30 IN YEAR 1 WITH PROMISED REPAYMENT
OF 50
BONDHOLDER-STOCKHOLDER CONFLICT
4. LIQUIDATION: SINGLE CLASS OF LENDERS
DEBT 500
FIRM VALUE
IMMEDIATE 480
NEXT YEAR
GOOD 600
BAD 200
Bondholder-Stockholder Conflict: Liquidation
with Multiple Classes of Lenders
Debt Obligations
Immediate Next Year
Debt holders 150,000 1,000,000
Venture Capitalist 0 200,000

1,200,000 if firm liquidated immediately
Payoff in the Event of Liquidation
Debt holders 1,150,000
Venture Capitalist 50,000
Stockholders 0
Bondholder-Stockholder Conflict: Liquidation
with Multiple Classes of Lenders
Next Year: States of the Economy
Immediate Favourable Unfavourable
Firm cash flows 1,500,000 500,000
Debt holders 150,000 1,000,000 500,000
Venture capitalist (150,000) 450,000 0
Stockholders 0 50,000 0

This assumes VC is promised 250,000 payment on 150,000
loan
Seasoned Equity Issue (Follow-
up Public Offer)
Myers-Majluf explanation for Pecking
Order
New Shareholder-Old
Shareholder
Managers know true future value of firm,
and of projects
Managers act in the interest of Old
shareholders
Old shareholders passive
Zero interest rate, no transaction costs
A: Issue Equity: No Positive
NPV Projects
DO NOTHING ISSUE EQUITY
GOOD BAD GOOD BAD
LIQUID ASSETS 50 50 150 150
ASSETS IN PLACE 200 80 200 80
VALUE OF FIRM 250 130 350 230
A1: Old Shareholders Payoffs:
Issue vs Do Nothing
DO NOTHING ISSUE EQUITY
GOOD NEWS 250 * 229.31
BAD NEWS 130 150.69 *
190/290*(350)=229.31
190/290*(230)=150.69
Is this an equilibrium?
B. Issue Equity: Positive NPV
Project
DO NOTHING ISSUE EQUITY
INVEST 100
GOOD BAD GOOD BAD
LIQUID ASSETS 50 50 50 50
ASSETS IN PLACE 200 80 300 180
NPV NEW PROJ. 0 0 20 10
VALUE OF FIRM 250 130 370 240
OLD SHAREHOLDERS' WEALTH
DO NOTHING=0.5*(250+130)=190
ISSUE/INVEST=0.5*(270+140)=205
B1: Old Shareholders Payoffs:
Positive NPV Project
DO NOTHING ISSUE EQUITY
INVEST 100
GOOD NEWS 250 * 248.69
BAD NEWS 130 161.31 *
205/305*(370)=248.69
205/305*(240)=161.31
Is this an equilibrium?
B2: Old Shareholders Payoffs:
Equilibrium
DO NOTHING ISSUE EQUITY
INVEST 100
GOOD NEWS 250 * 248.69
BAD NEWS 130 140.00 *