Hi,

i've been researching corporate finance and i had a little trouble understanding an agent principle problem. If you have a good grasp of this then no need to read all of this,you can skip right down to the questions.

So i understand that potential agency problems arise when there is a conflict of interest between the need of the principle and the needs of the agent. Now in finance there are two primary agency relationships, however the one im struggling to understand is that between the creditors and the stockholders. So below is the text i am trying to digest but i am struggling.

"Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is the main concern of creditors.
Stockholders, however, have control of such decisions through the managers.
Since stockholders will make decisions based on their best interest, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows."


What i understand by the above is that creditors will loan money to corporations, who then have the ability to spend it how they feel will best benefit the company. However stockholders will want the money to be spent on things that will primarily drive up stockprices in the short run with little concern for the long run affects on the company. And the long run effects will affect the companies ability to repay the creditors loan.


My main questions are as follows:

1. When viewing this concept of stockholders vs creditors, do we assume the manager just takes a puppet like position and follows the wishes of the shareholders, or is he trying to strike a balance between the interests of the creditor and the shareholder?

2. By using the loaned money from creditors to repurchase shares to lower the corporation share base, does this drive up stock holders return simply because the more shares bought the more the firm is worth and thus the more each share is worth?

3. I don't understand the creditor side of the deal. So the creditor loans money to the company, looking to make interest on the loan when it is eventually repayed. He dislikes the repurchasing of shares because his money becomes tied up in stocks in the company, and the balance sheets are showing debt?

How does using the creditors money to repurchase stocks affect the company's future cash flow?

How is there an increase in company debt? are the stocks not easily traded or sold?

thanks for any responses

1. I'm not sure. It varies. In general management should do what's best for the company. Equity holders naturally have more control since they take on much more risk than creditors. It's not a good idea to piss off creditors for obvious reasons though.

2. This is just converting debt to equity on the balance sheet. It makes the company look better (improve debt/equity, lower P/E etc). The market prices the changes and the stock will probably increase in value.

3. Interest is paid at regular intervals, not only at the time of repayment. Creditors dislike risk. They would rather the debt is used for "safe" operations instead of risky new projects for example.

Future interest payments, principle payments effect cash flow.

A principle agent problem would generally be that the manager pursues his own personal interests at the expense of the creditors and the shareholders. In order to solve this problem, creditors and shareholders try to offer incentives and monitor in order to reduce this problem. I'm not saying managers always pursue their own interests at the expense of these people, just that it's usually the principle agent problem I hear about.

I'm not exactly sure what you're asking. If a corporation bought up their own shares, this theoretically shouldn't change the price per share since a share is still worth 1/nth of the company. However, in reality, a corporation buying up shares may send a signal to shareholders that those inside the company have reason to believe the stock is undervalued (i.e. those with inside information think it's undervalued). Or if we're still talking about the principle agent problem, it's possible that the corporation owning more shares could potentially lead to better incentives, more efficiency, smarter decisions, etc, and therefore higher stock prices.

Again, I'm not completely sure what your asking (which is probably related to the fact that I'm new at this stuff). Are you asking, why do creditors loan money to the company instead of buying stock? If so, you have to understand that creditors get payed off first (i.e. have first dibs on the assets after bankruptcy, and therefore lower risk) and have a locked in interest rate (i.e. a fixed rate of return if the company has enough money to pay them). Basically, stocks and bonds/debt are just two different forms of investing money. Bonds/debt is less risky, so people are going to want to have them in their portfolio instead of stock in the company (just due to risk aversion and diversification, although in reality there are also other reasons to buy bonds/debt).

1. Depends on the manager. YougEcon is right about how the problem is usually looked at, but it can also be looked at in terms of creditors vs shareholders (usually this is for small business where the biggest shareholder is the manager). This is why creditors implement covenants (both positive and negative) wrt what the firms can do with the loaned money. 100% buy-back of shares wouldn't be allowed under most loan agreements unless the company was already at a very low leverage level.

2. In a world without taxes, the short answer is no, this wouldn't increase firm value. This is covered by Modigliani-Miller Theorem uner the no-taxes environment: http://en.wikipedia.org/wiki/Modigliani-Miller_theorem . Once you add taxes, because of the way taxation works in most modern states, the value of a firm does go up (as well as its risk) when it takes on debt (up to an optimal level) and thus the value will go up, and so will shares. In the short-term this change will be due to demand/supply of the shares themselves on the market, but in the medium- and long-term the only reasons those gains will stay is because of the increase in fundamental value that comes from the tax savings associated with debt, not because they decreased the share base. If a company bought back shares with its own retained earnings, it theoretically shouldn't increase value (it will in practice though, because most of the time when co's buy back their own shares it's because of other positive factors in the firm that will also lead to higher value). Read the M&M Theorem for better/more explanations.

3. I don't see the question in this. Looks more like a statement. But basically, creditors choose the terms on which they accept to loan, and most of the time those will include either collateral, or terms that make a total shift of the capital structure of the co. hard/impossible. They will make sure that positive cashflows must be maintained, etc. Also, bond holders have an incentive (assuming public debt, if private, then the bank fulfills this role) to monitor the firm. In the case of riskier firms, creditors can be offered such things as convertible bonds and other terms that greatly benefit them by limiting the downward risk on their debt's value.

When a company issues debt to buy up equity, they are increasing the share price. Issuing debt creates a tax shield benefit (Corporate Tax Rate * Total Debt) which in turns increases the levered value of the firm. E = V - D. You will have to see how many shares can be purchased and then calculate the new equity value with the tax shield and divide by the lower amount of shares.

I'm sure the creditors have covenants in place regarding leverage ratios and other ratios regarding debt. Just remember that in case of default, creditors will get all the assets ahead of the stockholders and there will be many different levels of creditors to pay off. The managers of a company aren't only a puppet for the shareholders. They also have a duty to the creditors.

Saying how the deb will affect future cash flow is hazy. Clearly more money will have to be spent on interest and retiring debt but the debt raised should help the firm in buying new assets or investing in the company which should increase profits.

As a manager of the company there does exist a principal agent problem because of how he is incentivized. If a manager with 5 million shares in options decides to retire, he can certainly leverage his company and increase the cash he himself will receive. This is more stealing from shareholders as the debtholders aren't suddenly owed less. They are owed the same, but the subtle risk they bear has increased. And you aren't stealing from someone if you just give them more risk.

In terms of shareholders versus creditors, there isn't a principle agent problem because management is not the agent of the debtholders. In fact creditors expect management to act against the creditors, hence non risk-free lending.

This entire line is wrong. Completely.

Even moreso is that if anyone is getting stolen from, it is the existing debtholders, not shareholders.
Shareholders have a monetary claim on residual cash flows only, nothing else, full stop [and a vote].

The last para was 100% correct though.

This line is not completely wrong. Unless the CEO cashes out to the level of impairment of ability to pay debt (which doesn't happen in real life due to covenants) the debt risk is increased but they still have first claim over equityholders, hence dividends will be lost before interest is lost.

Anyone else noticing an uptick in leveraged dividends of late?

sorry, my answers in the quote ( i must have typed it wrong) lol

and sorry for the grammatical mistake.. i typed it using my iphone.

The biggest agent disconnect is that managers don't represent shareholder interests in most public companies, they represent their own interests and shareholders have little or no ability to influence management decisions or even selection of management. In public companies without a substantial shareholder presence, management will work to maximize their own financial net worth through stock options, which give highly assymetrical upside returns. The easiest way to do that is to buy back shares and create upward pricing pressure on the stock, even if it involves leveraging the business and reducing it's credit worthiness. Debt holders usually don't have a say in the matter unless they have strong debt covenants in their debt agreement.

You have to qualify your statement to include that the repurchase occurs at an uneconomic level. If a company has $100 dollars in cash with no debt, and the stock trades at $80, then the manager should back shares until the marginal interest paid matches the marginal interest received for a given level of risk.

A+