Corporate Finance: European Edition (UK Higher Education Business Finance) by David Hillier

Corporate Finance: European Edition (UK Higher Education Business Finance) by David Hillier

Author:David Hillier [Hillier, David]
Language: eng
Format: azw3
ISBN: 9780077173630
Publisher: McGraw-Hill Inc., Us
Published: 2016-03-10T16:00:00+00:00

Like any entrepreneur, Ms Wolfe can choose the degree of intensity with which she works. In our example, she can work either a 6- or a 10-hour day. With the debt issue, the extra work brings her £100,000 (= £160,000 − £60,000) more income. However, let us assume that with an equity issue she retains only a one-third interest in the equity. Here, the extra work brings her merely £33,333 (= £133,333 − £100,000). Being human, she is likely to work harder if she issues debt. In other words, she has more incentive to shirk if she issues equity.

In addition, she is likely to obtain more perquisites (a big office, a company car, more expense account meals) if she issues equity. If she is a one-third shareholder, two-thirds of these costs are paid for by the other shareholders. If she is the sole owner, any additional perquisites reduce her equity stake alone.

Finally, she is more likely to take on capital budgeting projects with negative net present values. It might seem surprising that a manager with any equity interest at all would take on negative NPV projects: the share price would clearly fall here. However, managerial salaries generally rise with firm size, providing managers with an incentive to accept some unprofitable projects after all the profitable ones have been taken on. That is, when an unprofitable project is accepted, the loss in share value to a manager with only a small equity interest may be less than the increase in salary. In fact, it is our opinion that losses from accepting bad projects are far greater than losses from either shirking or excessive perquisites. Hugely unprofitable projects have bankrupted whole firms, something that even the largest expense account is unlikely to do.

Thus, as the firm issues more equity, our entrepreneur will likely increase leisure time, work-related perquisites and unprofitable investments. These three items are called agency costs because managers of the firm are agents of the shareholders.7


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