Corporate Finance Principles: Agency, Bonds, and Valuation
A1. The Agency Relationship in Public Companies
An agency relationship exists when a principal hires an agent to make decisions on their behalf. In a publicly listed company, shareholders are the principals (owners), and managers and directors are the agents (operators).
Why It Arises
It stems from the separation of ownership and control. Listed companies have thousands of dispersed shareholders who delegate management to professionals.
The Agency Problem
Managers may pursue personal interests over shareholder wealth, such as:
- Empire building: Growing the firm for status.
- Risk aversion: Avoiding profitable but risky projects.
- Short-termism: Manipulating earnings for bonuses.
This is exacerbated by information asymmetry and the free-rider problem in monitoring.
Agency Costs and Control
Costs include monitoring (audits), bonding (incentive contracts), and residual loss. Conflicts are mitigated via performance-linked pay, independent boards, the market for corporate control, and debt discipline.
A2. Advantages and Disadvantages of Public Listing
Advantages
- Capital Access: Ability to raise significant equity via IPOs and rights issues, often at lower borrowing costs.
- Liquidity: Shares trade freely, allowing founders to diversify wealth and providing a currency for acquisitions.
Disadvantages
- High Costs: Significant listing, regulatory, and audit expenses, plus potential double taxation.
- Loss of Control: Exposure to hostile takeovers and pressure to meet short-term earnings targets.
A3. Interest Rate Risk in Corporate Bonds
Interest rate risk is the sensitivity of a bond’s price to changes in market interest rates. Bond prices and yields move in opposite directions.
Key Concepts
- Price Risk: Capital loss if rates rise before maturity.
- Reinvestment Risk: Lower returns when coupons are reinvested at lower rates.
Sensitivity increases with longer maturity and lower coupons. Corporate bonds also face credit risk and call risk if the bond is callable.
A4. NPV vs. IRR: Investment Appraisal
Net Present Value (NPV)
- Advantages: Directly measures shareholder wealth creation and is value-additive.
- Disadvantages: Highly sensitive to discount rate estimates and ignores project scale.
Internal Rate of Return (IRR)
- Advantages: Intuitive percentage-based metric; useful when the cost of capital is uncertain.
- Disadvantages: Can yield multiple solutions for non-conventional cash flows and may rank mutually exclusive projects incorrectly.
A5. Systematic Risk and Portfolio Theory
- Systematic Risk: Market-wide risk (e.g., inflation, recession) that cannot be diversified away. Measured by beta.
- Efficient Portfolios: Portfolios offering the highest return for a given risk level, forming the efficient frontier.
- Tangent Portfolio: The optimal risky portfolio with the highest Sharpe ratio.
- Security Market Line (SML): A graphical representation of CAPM plotting expected return against beta. Correctly priced assets lie on the SML.