Syllabus B. Advanced Investment Appraisal B3. Impact of financing on investment decisions and APV

B3h. Agency effects 17 / 18

Syllabus B3h)

h) Assess the impact of financing and capital structure upon the organisation with respect to:

iv) Agency effects.

Agency effects

Agency costs have a further impact on a firm’s practical financing decisions.

Where gearing is high, the interests of management and shareholders may conflict with those of creditors.

Management may for example:

  1. gamble on high­risk projects to solve problems

  2. pay large dividends to secure company value for themselves

  3. hide problems and cut back on discretionary spending

  4. invest in higher risk business areas than the loan was designated to fund.

In order to safeguard their investments lenders/debentures holders often impose restrictive conditions in the loan agreements that constrains management’s freedom of action.

These may include restrictions:

  1. on the level of dividends

  2. on the level of additional debt that can be raised

  3. on acceptable working capital and other ratios

  4. on management from disposing of any major asset without the debenture holders’ agreement.

These effects may:

  1. encourage use of retained earnings

  2. restrict further borrowing

  3. make new issues less attractive to investors.