FINS5514: Capital Budgeting and
Financing Decisions
Lecture 1: Overview and Agency Theory
Topics Covered Today
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• Objectives of the firm
• Agency theory
• Asymmetric Information/ Signaling
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• Financial managers make 3 broad decisions:
– Investment (Capital budgeting)
– Financial (Capital structure)
– Dividends
• All decisions theoretically separate but practically
interwoven
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Investment Decision
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• Decisions that create profit and revenue, as well as
those that reduce costs and expenses
• Bottom line is to increase firm value
• What long-term investments or projects should the
business take on?
• Capital budgeting analysis is therefore necessary to
incorporate:
– Risk of cash flows
– Timing of cash flows
5The balance-sheet model of the firm
Current
assets
Fixed assets:
- tangible
- intangible
Assets Liabilities/Shareholders’ equity
Shareholders’
equity
Current
liabilities
Long-term
debt
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The capital budgeting decision
What long-term
investments
should the firm
engage in?
Current
assets
Fixed assets:
- tangible
- intangible
Assets Liabilities/Shareholders’ equity
Shareholders’
equity
Current
liabilities
Long-term
debt
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The capital budgeting decision - examples
Date 0 1 2 3
CF -100 5 5 110
Project 1: cash flows of the project
Date 0 1 2 3 4 5
CF -100 5 5 5 5 110
Project 2: cash flows of the project
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Financing Decision
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• How to raise additional funds to invest:
– Debt
• Straight or convertible
• Long or short term
• Fixed or floating rate
– Equity
• Ordinary or preference shares
• Choice depends upon:
• Tax implications, External monitors, Firm risk, Matching,
Signaling, Agency Theory
• Capital structure
Capital structure
How can the firm
raise the money
for the required
investments?
Current
assets
Fixed assets:
- tangible
- intangible
Assets
Shareholders’
equity
Current
liabilities
Long-term
debt
Liabilities/Shareholders’ equity
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Firm Objective
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• What should be the goal of a corporation?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize the current value of the company’s stock?
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• Corporate wealth maximisation (CWM):
– Satisfy all stakeholders in firm, including:
• Debtholders
• Employees
• Society
– This model is used in Germany and Japan
• Shareholder wealth maximisation (SWM)
– This is the most popular answer
– Main objective of the firm is to maximize shareholder
value
– Equivalent to increase share price if listed
– Ethical issues : shareholders may expropriate wealth from
other stakeholders
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The Agency Problem
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• Under SWM, managers should be concerned only with
the shareholders’ welfare, but are they?
• Agency relationship
– Principal hires an agent to represent his/her interest
– Stockholders (principals) hire managers (agents) to run the
company
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• Jensen & Meckling (1976) state that the firm is a nexus
of contracts
• All stakeholders of the firm are concerned only with self-
interest
• This creates conflicts of interest between:
– Shareholders and managers
– Shareholders and debtholders
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Agency Conflicts - Shareholders/Managers
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• Managers prefer to:
– Increase their job security
– Increase their own power and status
– Consume excessive perquisites
• They may do this at the expense of SWM
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• Shareholders know this, and therefore attempt to
protect against it by:
• Linking managerial salaries to firm performance
• Limit the free cash flows under managerial discretion
• Monitor managers through, for example, audits or tighter
shareholder concentration
• All of the activities of shareholders to decrease agency
conflicts occur at a cost, called, agency costs.
– Changes in policy
– Opportunity costs if managers unable to invest in positive
NPV projects
– Monitoring costs
Other mechanisms:
• The Board of Directors
– Employing independent directors on the Board.
• The market for corporate control (mergers and
acquisitions) can use used to solve the agency
problem
– Shareholders can threaten to sell their shares in a hostile
takeover
– If the takeover goes ahead, the firms managers are likely to
be fired afterwards.
– This is viewed as the “court of last resort” (Jensen 1988)
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Agency Conflicts - Shareholders/Debtholders
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• Asset substitution:
• Managers switch/substitute higher risk for lower risk projects
on debtholders
– invest in assets that are riskier than what bondholders want
– debtholders have a fixed claim while shareholders have a
residual claim on the firm
– Shareholders prefer to invest in riskier project (greater risk,
greater return).
– increases risk that bondholders will bear due to increased risk
of bankruptcy.
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• Agency Costs
– Debtholders protect themselves through covenants, by
charging higher interest rates, or refusing to deal with the
firm => bad for s/h
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Types of Agency Problems
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• Moral Hazard(HiddenAction)
– Although the principal and the agent have the same initial set
of information, the principal cannot observe the action chosen
by the agent
• AdverseSelection(HiddenInformation)
– Both the principal and the agent know that the agent has
information which is valuable to the principal but which the
principal cannot see
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Asymmetric Information/ Signaling
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• One potential cause of agency problems is
asymmetric information
• Managers have more info than outsiders, including
shareholder and debtholders
– Akerlof (1970) market for lemons
– With no signals, markets break down – sellers will not
sell, buyers will not be able to buy
• He used the market for second hand cars as an
example
– Twotypesof secondhandcars
– Lemons–poor quality carswhich areworth$400
– Peaches– goodquality carswhich are worth $2,000
– Each type of carrepresents50%of themarket
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• There are 3 scenarios to consider
• Peaches and lemons can be accurately
identified by everyone in the market
– Here is there is no problem because everyone
has all the necessary information.
– Cars will be sold at their correct values and the
market will continue to operate
– A peach will be sold for $
and a lemon for $
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• No-one knows whether any particular car is a
peach or a lemon
– Assuming risk neutrality, buyers will work out
what they are prepared to pay:
E(Value) = Proportion of lemons x Value of lemon
+ Proportion of peaches x Value of peach
– In this example, this is:
– So, all cars will sell at $
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• Asymmetric information in which the sellers
know the quality of the car but buyers do not.
– Here the market will break-down
– Sellers of good cars will only accept $
but buyers will not pay more than $
– Therefore, no good cars will be sold and the only
cars on the market will be lemons
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• Solutions:
– Buyers gain their own skills => costly
– Sellers signal that their cars are not lemons, by:
• Warrantees
• Trial periods
– Effective signals are:
• Costly
• Credible
• Unambiguous
• Cannot be mimicked
– Consequently, a mere statement by the sellers that the car is
good is not an effective signal
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• The same as the market for lemons, managers will
attempt to signal to investors that the firm is not a
lemon.
• Briefly, this may be done through corporate
announcements, such as:
– Dividends
– Capital restructuring
– Takeover plans
– Initial Public Offerings
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CorporateGovernance
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• Name for any measures that can be used to close the
incentive gap between managers and shareholders
and reduce agency problems
• Some firm level solutions are on the previous slides
• To illustrate why this is important, consider a
situation where governance failed:
– The collapse of Enron (see reading and tutorial questions)
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CountryLevelCorporateGovernance
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• Corporate governance also exists at a country
(macro) level
• E.g. Sarbanes-Oxley Act (2002), Dodd–Frank Act
(2010)
• These regulations try to encourage / force firms to
act in the best interests of their shareholders
• However, is difficult to get the balance correct
between enforcing good governance and still
allowing firms to evolve and react to changing
situations
Cash flow
from firm (C)
The firm and the financial markets
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T
a
x
e
s
(
E
)
Government
Firm issues securities (A)
Retained
cash flows (D)
Dividends and
debt payments (F)
Firm
Invests
in assets
(B)
Current assets
Fixed assets
Financial
markets
Short-term debt
Long-term debt
Equity shares
Ultimately, the firm
must be a cash
generating activity.
The cash flows from
the firm must exceed
the cash flows from the
financial markets.
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3
0
Money markets versus capital markets:
• Money markets:
– For short-term debt instruments.
• Capital markets:
– For long-term debt and equity.
Financial markets
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3
1
Primary versus secondary markets:
• Primary market:
– When a corporation issues securities, cash flows from
investors to the firm.
– Usually an underwriter is involved.
• Secondary markets:
– Involve the sale of “used” securities from one investor to
another.
– Securities may be exchange traded or traded over-the-
counter in a dealer market.
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Firms
Investors
securities
SueBob
Stocks and
Bonds
Money
money
Primary Market
Secondary
Market
Financial markets
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• Three important questions in corporate finance
Capital budgeting
Capital structure
Dividends
• The goal of the corporation
Maximize shareholder’s value
• Agency problems
• Financial markets
Summary
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