Chapter 14, Page 1 of 7

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 firms 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 investments 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 opportunity for an agent to take unobserved actions for personal benefit to the detriment of the
principal.

5. A free rider is one who receives benefit from someone elses expenditure simply by imitation. One free-rider problem is
the copying of pharmaceuticals. Drug companies spend hundreds of millions of dollars on research and development to
discover new drugs. Other drug firms are able to duplicate the drug and produce it themselves, without the research and
development costs. In the United States, patents protect pharmaceutical companies for a limited time from facing
competition from the free-riding firms.

6. An agency problem is a potential conflict of interests between the agent and the principal. One agency problem is the
ability of an employee to slack off during working hours. Another agency problem is the ability of a manager to make
the decision to grow a company to a large size rather than maximizing shareholders wealth. Another agency problem is
the ability of the stockholders to gamble with the bondholders money by means of asset substitution.

7. Managers may have the goal of increasing the size of a firm to increase their own power and wealth rather than the
shareholders wealth. Another goal of the managers may be to receive extensive perquisites such as a company car,
expense accounts and a large office at the expense of the shareholders. Also, managers may have the goal of enjoying
their work time and shirking their responsibilities to the shareholders.

8. Agency costs are the costs of making agents act in the best interest of the principal. The components are direct
contracting costs, monitoring costs, and the misbehavior costs of agents not acting in the best interest of the principal.
An example of direct contracting costs is an employee bonus. An audit is an example of a monitoring cost. Shirking by
employees is a cost caused by agents not acting in the best interest of their employer.

9. Asset uniqueness can cause an agency cost to shareholders because they have to pay employees a risk premium for their
specialized talent that is not valuable to other employers. Shareholders also would have to pay a higher interest rate to
debtholders for bearing the risk of accepting the unique assets as collateral.

10. Employee perquisites create a conflict between the employees and the shareholders because employees can use a
company car or an expense account for their own personal business instead of for the intended use of conducting the
firms business.

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11. Product and service guarantees can create an agency problem between a consumer and a firm because the firm has the
option to default and not honor the guarantee.

12. One device that naturally monitors an agents behavior is the right of the principal to fire the agent. Another natural
device that monitors a managers behavior is the threat of a takeover. The shareholders right to elect the new directors
who monitor manager behavior is a third device. Incentive compensation can be an effective monitor because it aligns
the goals of the agent and the principal. The legal system also acts as a monitor on an agents behavior. A multilevel
organization is also a natural monitor of agents as employees work hard to earn promotions. The shareholders right to
sell their shares because a lower share price can be signal that managers are not doing a good job.

13. An optimal contract is a contract the minimizes total agency costs by balancing contracting, monitoring, and misbehavior
costs.

14. Bond covenants help reduce agency costs because they are a cost-effective method of monitoring the financial status of
the firm. Also, bond covenants can protect bondholders against the agency problem of asset substitution. The reduced
monitoring costs and the reduction in risk can result in a lower cost of borrowing for the firm.

15. Debtholders require a restriction on the firms ability to issue new debt because debt issuance can dilute their claim on
the firm and increase their risk. Two common covenants are that a firm must maintain a certain debt to asset ratio or a
certain interest coverage ratio.

16. Common stockholders may view their equity as a call on the firms assets written to them by the debtholders.
Stockholders may accept a negative-NPV project to increase the risk of the firm, thus causing the value of their call
option to rise. This is the asset substitution problem.

17. If stockholders view their equity as an option on the firms assets (written to them by the debtholders), stockholders
might reject a positive-NPV project. This is because the project would decrease the risk of the firm, and cause the value
of their option to fall by more than the projects NPV. The debtholders would get the difference that the stockholders
would lose. This situation is the underinvestment problem.

18. Claim dilution reduces the debtholders value by increasing the ratio of debt to the value of the assets supporting the
claim. Claim dilution via dividends increases this ratio by reducing the value of assets supporting the debt. Claim
dilution via new debt increases this ratio by increasing the both the amount of debt and the amount of assets. Limited
liability gives stockholders an option on the firms assets (written to them by the debtholders), so the increase in risk
(higher debt ratio) increases the value of their option and decreases the debtholders value.

19. By making a manager a stockholder, conflicts of interests can be reduced because the goals of the manager and other
stockholders will be more similar. If the manager acts in the best interest of the stockholders, he is also acting in his own
best interest.

20. Throughout a career, a person learns many things connected with that career, and especially things connected with his or
her employers. If the industry shrinks or disappears (such as certain manufacturing jobs in the U.S.), the person may not
have a good alternative place to work that would use the things they have learned over their career. Essentially, their
human capital is not very well diversified. It is instead focused on particular industries and employers. This is very
different from a persons financial capital, which can be invested in many different industries and firms. The lack of
diversification in human capital causes goal divergence between employees with their human capital and stockholders
with their financial capital.

21. Stockholders diversify their financial investment in the firm, and therefore care only about non-diversifiable risk.
Employees human capital is hard to diversify, and they care about the firms total risk because they bear diversifiable
and non-diversifiable risk. This can cause a conflict of interest because employees will prefer diverse capital
investments that limit their risk, while shareholders prefer the highest-NPV investments, even if the investment has very
high total risk.



Chapter 14, Page 3 of 7
22. An agents good reputation has an implicit guarantee of good performance, because of which the agent can get higher
wages and promotions. The agents cost of misbehaving can be high because misbehavior can ruin the agents
reputation and cause the agent to forego higher wages, or even lose his or her job. The reputation facilitates monitoring
because the agent is less likely to misbehave if the cost to their reputation is large.

23. In financial distress, the bondholders claim on the firms assets is contingent to default. Financial distress can intensify
the conflict of interests between shareholders and bondholders because of the probability of the shareholders losing
control of the firm and their investment. Shareholders may engage in asset substitution and underinvestment, seek new
loans, and fight protracted court battles to keep their equity.

24. The stock price of firm in bankruptcy is never negative because of the limited liability of equity. The stock price is
always positive because the stock represents an option on the firms assets, and an options value cannot be negative.

Challenging Questions

25. Incentive compensation is a common method used by shareholders to align the goals of a manager with their own.
Another method is the stockholders ability to elect directors and the directors ability to fire a manager. Also, the threat
of takeover can align the goals of a manager to those of the stockholders because shareholders have the right to sell the
stock of a poorly performing firm.

26. Monitoring is not always the best choice because the cost of monitoring may exceed the expected misbehavior costs. If
the cost of monitoring is more than the expected misbehavior costs, monitoring would not provide the optimal contract

27. A firm should not generally use the most restrictive set of covenants. Rather it should use the set of covenants that
provides the lowest total cost, including opportunity costs. The most restrictive set of covenants would have a number of
overlapping covenants. This is like the value of overlapping options which can be less than the sum of individual option
values. The overlapping covenants may not provide the bondholders any added protection but may cost the firm a lot of
flexibility. A covenant restricting new business lines may prevent the firm from undertaking a positive-NPV project
with greater value than the firm gained from lower interest rates associated with the covenants. The firm may lose
valuable options, such as the option to undertake a new project, because of the restrictive covenants.

28. Agency problems result because of asymmetric information. If there was no asymmetric information, the principal
would know everything the agent does and the agent would not take any actions that were not in the best interest of the
principal. That is why perfect monitoring eliminates agency problems.

29. The shareholders can resist any settlement and inflict costs on the debtholders. Essentially, the shareholders have the
option to make trouble. The debtholders sometimes purchase this option by making a payment to the shareholders
and avoiding a costly and lengthy legal battle, thereby enabling them to get their money earlier and avoid higher legal
fees.

30. A debtholder should be concerned about a firms dividend policy. A firm could pay a large dividend to its shareholders,
causing a reduction in the owners equity and an increase in the percentage of debt financing of the assets. The debt
would then be riskier and its value would fall.

31. Employee perquisites could create an agency problem between managers and debtholders if there was little or no
stockholders equity. If a company was operating in bankruptcy and the stockholders equity was zero, the managers
would be funding their perquisites with the debtholders money.

32. A multilevel organization can provide a form of agent monitoring through the use of promotion. Employees with the
best reputations will be the agents that are promoted through the levels of the corporation. Agents with good reputations
are unlikely to misbehave because the cost of misbehaving is high. Other agents will mimic the agents with good
reputations hoping to be promoted to higher positions with higher pay.

33. A convertible bond can reduce the agency problem between the shareholders and debtholders because it helps to align
the goals of both parties. The debtholders can share in the upside potential of the firm by converting their bonds to
common stock. Stockholders are not the only ones who stand to benefit through the firms risky behavior, the
debtholders can benefit as well.
Chapter 14, Page 4 of 7

34. It should be possible to predict what claimant coalitions will form during a financial distress because of the Principal of
Self-Interested Behavior. The claimant coalitions could be predicted by looking at the set of contracts and determining
what each party has to gain or lose in the case of financial distress.

Problem Set A

A1. Total Cost =Contract Costs +Monitoring Costs +Misbehavior Costs
Total Cost =$1.00 - $0.40 - $0.95 =-$0.35, so the net benefit is $0.35 million.

A2. Total Cost =Contract Costs +Monitoring Costs +Misbehavior Costs
Total Cost A =$4.5 +$3.5 +$7.0 =$15
Total Cost B =$6.0 +$2.5 +$4.5 =$13
Total Cost C =$8.0 +$2.0 +$3.5 =$13.5
Contract B is optimal.

A3. a. Total Cost =Contract Costs +Monitoring Costs +Misbehavior Costs
$0 =Contract Costs +$750,000 +Misbehavior Costs
Contract Costs +Misbehavior Costs =-$750,000
Direct Contracting Costs and Misbehavior Costs must decrease by $750,000.
b. Total Cost =Contract Costs +Monitoring Costs +Misbehavior Costs
$0 =-$250,000 +$750,000 +Misbehavior Costs
Misbehavior Costs =-$500,000
Misbehavior Costs must decrease by $500,000.

A4. a. Interest Payment =$500,000 x 12% =$60,000
Net Profit =$60,000 - $15,000 =$45,000
r =$45,000 / $500,000 =9.0%
b. Net Profit =$500,000 x 10% =$50,000
Interest Payment =$50,000 +$15,000 =$65,000
Interest Rate =$65,000 / $500,000 =13.0%

A5. a. Surplus =Assets - Obligations
Surplus =$90 - $80 =$10 million
b. Surplus =Assets - Obligations
Surplus =($90 - $18) - $80 =-$8 million

A6. Peachtree should call the debt and pay the $5 million penalty. The project could then be undertaken for an NPV of
$20 - $5 =$15 million.

A7. a. $8.00 x 2 billion =$16 billion
b. $5.00 x 800 million =$4 billion

Problem Set B

B1. a. Value Equity =Max[$0; $90 +$20 - $100] =$10 million
Value Debt =Min[$100; $90 +$20] =$100 million
b. Value Equity =Max[$0; $90 - $20 - $100] =$0
Value Debt =Min[$100; $90 - $20] =$70 million
c. Expected NPV =0.25 x $20 +0.75 x -$20 =-$10 million
Expected Firm Value =$0 +$90 +-$10 =$80 million
d. Expected Equity Value =0.25 x $10 +0.75 x $0 =$2.5 million
Expected Debt Value =0.25 x $100 +0.75 x $70 =$77.5 million
e. Stockholders benefit from the negative-NPV project because they are using the debtholders money to finance a risky
project that they alone can benefit from. This is known as asset substitution.

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B2. (1) $800,000 - $500,000 =$300,000
(4) ($100,000 x 4 +$120,000) / 2 =$260,000
Misbehavior Costs =$300,000 +$150,000 +$150,000 +$260,000 +$40,000 =$900,000

B3. a. Bonus =8% x $2,000,000 =$160,000
Dividend =$0.75 x 20,000 =$15,000
b. Bonus =15% x $2,000,000 =$300,000
Dividend =$0.75 x 400,000 =$300,000
b. Sharons Bonus =8% x $1,000,000 =$80,000
Sharons Dividend =$1.00 x 20,000 =$20,000
Marilyns Bonus =15% x $1,000,000 =$150,000
Marilyns Dividend =$1.00 x 400,000 =$400,000
c. Sharon and Marilyn will both favor the plan with the $2,000,000 bonus and the $0.75 dividend.

B4. a. Expected Payment =0.50 x Min[$500,000; $600,000] +0.50 x Min[$500,000; $700,000]
Expected Payment =$500,000
b. Expected Payment =0.50 x Min[$500,000; $350,000] +0.50 x Min[$500,000; $950,000]
Expected Payment =$425,000

B5. a. Expected Payment =$100
b. % of Debt =$100 / ($100 +$150) =40%
Claim on Assets =$200 x 40% =$80

B6. Cash =$100,000 - $40,000 - $60,000 =$0
Value of Loan =$0

B7. a. There is no effect on the firms taxable income, taxes due or net income from a dividend.
After-tax Cash Outlay =$1,000,000
b. Taxable Income decreases by $1,000,000
Taxes Due decrease by $1,000,000 x 40% =$400,000
Net Income decreases by $1,000,000 - $400,000 =$600,000
After-tax Cash Outlay =$600,000

Chapter 14, Page 6 of 7
B8. a.
Assets Debt Equity
Low Value $ 800.00 $ 800.00 $ 0.00
High Value $1,200.00 $1,000.00 $ 200.00
Expected $1,000.00 $ 900.00 $ 100.00

b.
Assets Debt Equity
Low Value $ 700.00 $ 700.00 $ 0.00
High Value $1,300.00 $1,000.00 $ 300.00
Expected $1,000.00 $ 850.00 $ 150.00
NPV =-$1,000 +$1,000 =$0

c.
Assets Debt Equity
Low Value $ 600.00 $ 600.00 $ 0.00
High Value $1,300.00 $1,000.00 $ 300.00
Expected $ 950.00 $ 800.00 $ 150.00
NPV =-$1,000 +$950 =-$50

d.
Assets Debt Equity
Low Value $1,000.00 $1,000.00 $ 0.00
High Value $1,100.00 $1,000.00 $ 100.00
Expected $1,050.00 $1,000.00 $ 50.00
NPV =-$1,000 +$1,050 =$50

e.
Assets Debt Equity
Low Value $ 0.00 $ 0.00 $ 0.00
High Value $2,000.00 $1,000.00 $1,000.00
Expected $ 200.00 $ 100.00 $ 100.00
P High = 10%
NPV =-$1,000 +$200 =-$800

Because the high value of equity is $1,000, a 10% probability is all that is required to match the initial expected
equity value of $100. Because the low value is zero, the expected value of the assets, debt and equity are equal to
10% of the high value.

Chapter 14, Page 7 of 7
Problem Set C

C1. a. Expected Payment =0.50 x Min[$20; $25] +0.50 x Min[$20; $50] =$20 million
b. % of Debt =$20 / ($20 +$15) =57.14%
Expected Payment =0.50 x Min[$20; $25 x 57.14%] +0.50 x Min[$20; $50 x 57.14%]
Expected Payment =$17.14 million

C2. a. Value Equity =Max[$0; $102 +$20 - $100] =$22 million
Value Debt =Min[$100; $102 +$20] =$100 million
b. Value Equity =Max[$0; $102 - $20 - $100] =$0
Value Debt =Min[$100; $102 - $20] =$82 million
c. Expected NPV =0.25 x $20 +0.75 x -$20 =-$10 million
Expected Firm Value =$0 +$102 +-$10 =$92 million
d. Expected Equity Value =0.25 x $22 +0.75 x $0 =$5.5 million
Expected Debt Value =0.25 x $100 +0.75 x $82 =$86.5 million
e. Stockholders benefit because the gain from debt expropriation exceeds the loss on the project.

C3. a. No catastrophe: Assets =$10,000
Debt =Min[$6,000; Assets] =$6,000
Equity =$10,000 - $6,000 =$4,000
Catastrophe: Assets =$0
Debt =Min[$6000; Assets] =$0
Equity =$0 - $0 =$0
E[Debt] =0.98 x $6,000 +0.02 x $0 =$5,880
E[Equity] =0.98 x $4,000 +0.02 x $0 =$3,920
b. No catastrophe: Assets =$10,000 - $1,000 =$9,000
Debt =Min[$6,000; Assets] =$6,000
Equity =$9,000 - $6,000 =$3,000
Catastrophe: Assets =$10,000
Debt =Min[$6000; Assets] =$6,000
Equity =$10,000 - $6,000 =$4,000
c. E[Debt] =0.98 x $6,000 +0.02 x $6000 =$6,000
E[Equity] =0.98 x $3,000 +0.02 x $4,000 =$3,020
E[Debt] increased by $6,000 - $5,880 =$120
E[Equity] decreased by $3920 - $3,020 =$900
The debtholders benefited.

C4. a. CALC: n =4 r =? PV =-$200,000 PMT =$22,000 FV =$200,000 r = 11.00%
b. CALC: n =4 r =? PV =-$200,000 +$10,000 =-$190,000 PMT =$22,000 +$1000 =$23,000
FV =$200,000 r = 13.19%