BFN3104

Agency Theory
Questions
1.

In your own words, describe a principal-agent relationship. Cite 2 examples each

of explicit and nonexplicit principal-agent relationships.
A principal agent relationship is a relationship where an agent makes decisions that
affect the principal. Examples of explicit principal agent relationship 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, which can affect a manufacturer.

2.

What is an agency cost? What are its 3 components? Cite an example of each.
Agency costs are the cost 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 employee is a cost caused by agents not acting in the best interest of their
employer.

3.

What methods do shareholders have at their disposal for aligning managers goals
with their goals?
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 directors ability to fire a manager. Also, the threat of takeover can align
the goals of manager to those of the stockholders because shareholders have right to
sell the stock of a poorly performing firm.

4.

Is it possible to have an agency problem if there is no asymmetric information? If

so, cite an example; if not, explain why not?
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 principal. That is
why perfect monitoring eliminates agency problems.

5.

We said that in case of financial distress, various claimant coalitions can form. Is
it possible to predict what those conditions will be when the firms is healthy? If so,
explain. If not, explain why?
It should be possible to predict what claimant coalitions will form during a financial
distress because of the principal of self-interest 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.

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Problems
1.

Estimates of direct, monitoring, and misbehaviour costs for 3 different managerial

contracts are given here. Which of the contracts is optimal?
CONTRACT
A
B
C

CONTRACT
COSTS
$2.8
4.6
10.0

MONITORING
COSTS
$6.2
1.5
1.0

MISBEHAVIOUR
COSTS
$4.0
7.5
1.2

Total cost = contract cost + monitoring costs + Misbehaviour costs

Total cost A = $13.0
Total cost B = $13.6
Total cost C = $12.2
Contract C (lowest cost) is optimal.
2.

Michigan Mining and Manufacturing has a debt obligation of $100 million and
assets with a value of $90 million. This debt must be paid off very shortly. When this
happens, the value of the debt will be $90 million and the value of equity will be $0.
prior to paying off the debt, MMM has an opportunity to make a high-risk
investment. MMM is considering an investment of $20 million (from existing assets)
that will pay off $40 million or zero. The investment would have an NPV of either
$20 million or -$20 million (NPV = the value of the payoff minus the investment).
The investment would be paid for with the firms liquid cash holdings.
a. If the $40 million payoff (NPV = $20 million) occurs, what is the value of equity?
What is the value of debt?
Value equity = max($0, $90+$20-$100) = $10million
Value debt = min($100, $90+$20) = $100million
b. If the zero payoff (NPV = -$20 million) occurs, what is the value of equity? What
is the value of debt?
Value equity = max($0, $90-$20-$100) = $0
Value debt = min($100, $90-$20) = $70million
c. Assume the probability of the high payoff is 0.25 and the probability of the low
payoff is 0.75. what is the expected NPV of the investment? What is the expected
value of the firm?
Expected NPV = (0.25*20) + (0.75*-20) = -$10million
Expected Firm Value = 0 + 90 -10 = $80million

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d. What is the expected value of equity? What is the expected value of debt?
Expected Equity Value = (0.25*10) + (0.75*0) = $2.5million
Expected Debt Value = (0.25*100) + (0.75*70) = 77.5million
Expected Firm Value = Expected Equity Value + Expected Debt Value
e. How can stockholders benefit from a negative-NPV project?
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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