After reading my article on agency costs you should have a fair idea of why agency relationships exist and how they can cause agency costs. In this article we will look at a common agency relationship between debtholder’s and shareholders. Debtholder’s provide debt to shareholders so that they may operate and pursue positive NPV projects. Debtholder’s expect shareholders to use the money provided appropriately. In other words, debtholders expect shareholders to act in such a way that does not destory debtholder’s wealth. The goal of debtholder’s is to protect their investment. Shareholder’s can destroy debtholder’s wealth by acting in their on self interest and pursuing the following:
1. Pay excessive dividends
2. Dilute existing debt claims
3. Substitute low risk investments for high risk investments
4. Forego positive NPV investments/pursue negative NPV projects
These actions transfer wealth away from bondholders to the firm. However debtholder’s are able to price protect by creating restrictions or covenants. These might include:
1. EBIT divided by interest expense must not fall below 3.5
2. Total Liabilities over total tangible assets must not fall below 0.5
3. Management cannot pay a dividend to shareholders if interest has not been paid
4. Shareholders cannot sell major assets without bondholder approval
However it is the shareholders that ultimately bear the costs of this relationship. This is beacuse debtholders are able to price protect. If they expect opportunistic behaviour to arise, they will demand a higher cost of capital and implement the above covenants. For example if debtholders expected shareholders to use the low interest debt to pursue high risk projects they woul demand a higher cost of debt.
Furthermore covenants can have material effects on the ability of a firm to operate. This can subsequently be very costly. For example introducing a covenant the requires debtholder approval for the sale of certain assets may limit a firms to pursue certain investments/projects.
Below is a practical example of use of covenants. It is an announcement made to the Australian stock exchange regarding a covenant facing Australian Investment bank, Babcock & Brown:
“Under the market capitalisation threshold clause (ie where BNB market cap is below A$2.5 billion or currently A$7.50 per share), the banks have no right, other than to consider whether they should call for a review. If a review is called there is a four month discussion period with Babcock & Brown about whether any course of action is required, if at all. If at the end of the four months, the group’s market cap is above the threshold level, the “event” is automatically cured.”
This was said to have contributed to the eventual collapse of Babcock & Brown in the end of 2008.
Hi, very nice post. I have been wonder’n bout this issue,so thanks for posting