Agency Problems between Debt and Equity Holders - Coursework Example

Agency Problems between Debt and Equity Holders

Introduction

The growth and development of a firm are encompassed with intrinsic relationships between the business and other financial institutions. The relationships enhance the developmental agenda of the firm. Nonetheless, there exist possible conflicts that arise from the relationships causing problems within the firm. Among those relationships, the most intrinsic to the financial structure and profitability of the firm is the relationship between debt and equity holders. Thus, recognizing the role of managers in any firm that has characteristics of value maximization of the firm’s stock in the market. The managers have been entrusted with the sole task to achieve the objective of the stockholders in the form of maximizing the profit of the firm and their wealth. The understanding and ability in the adaptation to the various facets of the business environment ensure the growth and development of the company and is characteristic of the skills of the firm managers (Huang, Ritter, & Zhang, 2016, p. 32). Nonetheless, the choices in finance mechanism of pertinent investment are intrinsic to the profitability of the firm. In this regard, the relationship between debt and equity holders has often reflected in the choices of financing investment and the ability of the firm to progress. Therefore, the paper will be categorical in the analysis of the relationship that exists between the debt and equity holders of any firm. Further, the paper will endeavor to uncover the possible conflict within which agency problems occur within that relationship. Finally, the paper will uncover consequences of the strained relationship between debt and equity holders to the financial structure of the firm.

Agency Problems

Profitability of a firm is often determined by the relationship that exists between several factors of the firm that include the internal and external facets. The managers are often in control of the internal factors while the external factors that are pertinent to the profitability of any investment are beyond the control of the firm managers. Encompassed by external factors, issues such as consumer behavior as well as changes within the policies of the government towards finance and business, affect the ability of the manager to make sound investments on behalf of the firm (Hamzah, & Zulkafli, 2014, p.121). The relationship between these factors often strains the nexus between the debt of the firm and the ability of the managers to make the sound investment to the advantage of the equity holders.

Cognizant of the major objective of the firm in the increase and maximization of the wealth of the stakeholders of the firm, there are varied interests that ensue and constrain the achievement of that objective. Among them is the compatibility between the interests of the managers of the firm and the interests of the stakeholders. While it would be in the best interest of the firm to maximize the wealth of the stakeholders, the interest of the managers is often conflicted out as that decision may not serve their interest within the firm. These conflict of interests cause agency problems that spill to the relationships of debt and equity holders within the firm. Consequently, the financial structure of the firm is determined by the outcome of the strong interest of both parties.

Causes of agency problem in Debt and equity relationship

The ability of a firm to make sound investments in the benefit of the stakeholder is determined by the ability of the firm to gain finances from the financing institutions. The lending relationship between the firm and financial institutions shape the nature of the forms investments depending on the risks pertained to the firm. For instance, cognizant of the united states financial institutions, a study conducted indicated that financial institutions have retained the ability restrict investment and borrowing on firms while considering the risk of bankruptcy of the firm (Nikolov, & Whited, 2014, p.1898). The interest of the financial institution, in this case, is the ability of extraction of surpluses from the firm over long stretches of time. Therein, the growth of the firm may be restricted by the interest of the financial institution if that growth is not compatible with its interest. For instance, the benefit of the financial institution is secured through a long-term lending relationship with the firm. Therefore, a continuation of that profitability will only be secure if the growth of the company does not impede that goal.

While it is in the best interest of the firm to have financial aid to sponsor the investment strategies of the firm, the debt incurred during such transactions limit the ability of the managers to make valuable choices in that interest. The process is reinforced by the set of constraints that exist between the shareholders of the firm and debtholders who finance the investment strategies. The conflict manifest in various facets of the decision-making process which includes: first, the investment choices that the firm has to consider. Hence, the firm only holds the strategies and the ability to implement that approach, while the debtholder has the financing mechanism of such investment. Secondly, the method through which the financial institution will finance the investment chosen. The process is in cognizant of the interests of the financial institution to profitability and long-term lending relationship, as opposed to the firm’s growth strategies (Christensen, 2016, p. 402). Thirdly, the method through which dividends will be paid out by the firm in consideration with the debt incurred during the investment and the interests of the shareholders of the firm.

The long-term value of the company and its profitability is determined by the balance between the debt structure of the firm and the risks involved such as those of bankruptcy. Cognizant of the ability of the debt of the firm not only to restrict cash flow of the firm but also exposes the firm to an increased risk of bankruptcy. The perspective of bankruptcy may differ in the legal and economic views. The legal perspective underscores as the mechanism through which the payments of debts by the firm are scheduled due to the financial distress of the firm. Nonetheless, the economic aspect emphasizes the construct as a mechanism through which resources are allocated. From a manager’s perspective, resources at their disposal are invaluable, and thus the firm must utilize the resources at its disposal while considering the debt burden within its finance structure. Another perspective asserts that the increase of the debt of the company may increase the market value of the firm (Pandher, & Currie, 2013, p.33). Nevertheless, the perspective is confined to the condition of bankruptcy levels being at their lowest point. Therefore, for the firm to reduce costs that are associated with equity, the managers of the firm must ensure the continued increase of the financial leverage of the company. For example, drawing from the case of the Enron scandal, the financials of the company revealed well concealed debts that the company owed the debtors therefore increasing the risk of bankruptcy of the firm. Enron finally filed for bankruptcy to offset the debt that its had incurred and therefore complicating the relationship of the shareholders of the company.

Implications of the agency problem

Acknowledgement of the potential increase in the firm’s market value due to the debt incurred from financial situations, the managers of the firm is restricted in the strategies to implement investments of the firm. It is lost or limited freedom and capability of the managers to maneuver the free cash flow in the firm. Therefore, such decisions are pertinent to the consideration of capital market to inform of the course of action to be taken. To the advantage of the shareholders of the firm, the increase in debt can be utilized as a tool to control the effects of the managers. The situation provides the managers with strong incentives to ensure that the firm can service the debt (Christensen et al. 2016, p. 428). The managers must utilize the resources and strategies at their disposal to generate financial resources to achieve the objective. Ownership claims can be restructured through the use of the financial leverage created by the firm. Further, as leverage against the managers, maximization of the value of assets of the company at the disposal of managers can be achieved through the change of aims and aspirations. Following through the example of Enron, the obligations of the managers was offset by the debt of over 600 million dollars through which they were obligated to make to maximize the market value of the firm. The attempt to do so was confronted by the financial restrictions presented by the debt and therefore the Enron managers sort to hide the debt to investors of the firm. The move would prove fatal for the firm as the operating finances could not hold long term investments and therefore the company collapsed.

The constrained relationship between the debt and shareholders of the firm is further propagated through manager’s obligations towards the shareholders and the bondholders. The interests of the shareholders and the bondholders may differ considerably due to the nature of debt within the company. The result is a decision making the process by the managers of the firm that is aligned to the interests of the bondholders at the expense of the shareholders of the firm. The process is reinforced by a system of limitations and restrictions that the bondholders place in their interests. For instance, the inclusion of protective covenants within the construct of bond agreement ensures the protection of the benefits of the bondholders in the decision-making process of the firm. Such restrictions by the bondholders further limit6e the ability of the company to make flexible choices in the control of the financial structure of the company (Dhaene et al. 2017, p.174). For instance, in the interest of the bondholders to minimize the risk of their investment, they may restrict the ability of the firm to issue further debt. Protective put within the bond agreement further ensures the bondholder in the attempt to return the bond before maturity and gain the face value of his investments.

The concept of protective covenants between the bondholder and the firm increases the constraints of the firm and even affect the financial structure through pertinent investments of the firms are made. For instance, the ability of the covenant to require the maintenance of the financial conditions that the bond was purchased. For example, the ability of the bond to put restrictions on the working capital requirements changes the functioning structure of the firm. Further, it may also put restrictions on the interest cover as well as the minimum levels of net worth. Other restrictions include the ability of the firm to dispose of assets. The outcome is that the financial structure and the degree of freedom of the managers are severely compromised to represent the interests of the shareholders of the firm. To offset the degree of freedom, managers make decisions that may hurt the value of the shareholders shares and equity. Exemplified by the Boeing Buyback, managers of the Boeing opted to buy back the shares of the company to regain control in terms of the direction of the investments made by the company. The process was driven by the fact that Boeing by the end of 2001 had over 130 thousand shareholders which compelled it to plausible investment choices due to the interests of the shareholders. The decision to buy back majority of its stock drove the process of the shares down. The process created a situation where the shareholders lost value of their equity to the firm.

Conclusion

The relationship between debt and equity takes various forms through which various implications are experienced by both the firm and the shareholders. The competing interests of these publics of the business produce the level of growth that the firm experiences. The former is cognizant of the reliability of the company on the financial institutions and debtors in making sound investments to the interests of the shareholders. Further, one must acknowledge that the conflict within the constraints in the above discourse increases the value or the firm as well as the market value. Nonetheless, entrenched conflict and problem may jeopardize the ability of the firm to achieve its core objectives.