Page 19 - FINAL CFA II SLIDES JUNE 2019 DAY 6

Agency costs of equity: Managers don’t bear the costs of READING 21: CAPITAL STRUCTURE
excessive compensation or taking on too much (or too little)
risk. Because shareholders are aware of this conflict, they try
to minimize these costs, and the net result net agency cost MODULE 21.2: FACTORS AFFECTING CAPITAL STRUCTURE
of equity: 3 components:

• Monitoring costs -supervising management, governance reporting, board of directors. Strong governance systems will reduce these!
• Bonding costs are assumed by management to assure shareholders that the managers are working in the shareholders’ best interest. (e.g. premiums for
insurance to guarantee performance and implicit costs associated with non-compete agreements).
• Residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.

Per the agency theory, use of debt forces managers to be disciplined on cash management; greater financial leverage tend to reduce agency costs.

Costs of asymmetric information: Managers have inside info than owners or creditors; these stakeholders then look for management behavior
that “signals” what knowledge management may have:
• Choice of debt sends a signal that management has confidence in the firm’s ability to make these payments in the future.
• Issuing equity is typically viewed as a negative signal that managers believe a firm’s stock is overvalued.

The cost of asymmetric information increases as the proportion of equity in the capital structure increases.

Pecking order theory, based on asymmetric information, is related to the signals sent to investors through financing choices. Financing choices follow a
hierarchy based on visibility to investors:
• Internally generated equity (i.e., retained earnings).
• Debt.
• External equity (i.e., newly issued shares).

Therefore, the pecking order theory predicts that the capital structure is a by-product of the individual financing decisions.