ACF Tutorial 2: Disciplinary role of debt (agency cost of free cash + bargaining power)

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  • Created by: charlie
  • Created on: 01-05-18 11:54
Agency cost definition
Conflict of interest between managers (increase firm size) and SH (increase firm wealth)
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Free cash flow
Operating business cash leftover after investing in all +ve NPV projects
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Agency cost associated with free cash flow: Issues
1) Asymmetric info (managers know more than SH) 2) Moral hazard (managers was to optimise own profits) 3) Managers waste free cash on -ve NPV projects/ wages/ hiring to achieve excess growth (instead of dividend payouts)
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Agency cost associated with free cash flow: Solutions
1) Debt issue for share repurchase (disciplines managers as DH have claims) 2) Corporate governance controlling mechanisms (pay schemes/ monitoring/ threat of dismissal)
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Agency cost associated with free cash flow: Industry issue
Large issue in firms with lots of cash with little growth projects (e.g. oil anticipation of price rises, when there was actual price fall with real IR increasing)
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Bargaining power of managers with employees: issue
Firms with more variable profits (more chance of excess liquidity) and unionised labour exert more rent-seeking behaviour
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Bargaining power of managers with employees: solution
1) Debt issue for share repurchase (disciplines managers to make payments to DH and not to unions)
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Trade-off with increasing debt
Disciplines managers Vs Costs of financial distress
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Other cards in this set

Card 2

Front

Free cash flow

Back

Operating business cash leftover after investing in all +ve NPV projects

Card 3

Front

Agency cost associated with free cash flow: Issues

Back

Preview of the front of card 3

Card 4

Front

Agency cost associated with free cash flow: Solutions

Back

Preview of the front of card 4

Card 5

Front

Agency cost associated with free cash flow: Industry issue

Back

Preview of the front of card 5
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