Advanced Corporate Finance 2019/20

Advanced Corporate Finance

Solutions for Exercise Sheet 7
Shareholder-Manager Conflict, Agency costs, capital structure and firm value

Perkscom is a management controlled firm with a fragmented ownership structure. The company
is entirely equity financed. Its core business produces a strong cash flow, but analysts estimate
that about 50% of the firm’s true cash flows are wasted in different types of private benefits and
non-profitable investments.
Currently the company produces a (remaining) cash flow of 20million per year. The cost of
capital is 10% and hence the firm’s market value is $200m or $20 per share for one of the
10million shares. We will neglect taxation for the following calculations.

a. An activist shareholder wants to buy 20% of the company’s stock. He wants the firm to
changes its capital structure by issuing 150million in debt and using this money to buy back
shares. This debt would be risk free and pay an interest rate of 5%. The activist shareholder
argues that leverage will discipline the management and lead to an increase in shareholder
value. Assume that if the firm is levered up the management wastes 50% of cash after
interest payments. By how much should the increase in leverage increase firm value?

Pre waste cash flow = 40M. Interest costs are 150m*0,05=7,5m, hence 40m-7,5m=32,5m. Of
this half are wasted which gives 16,25 remaining cash to equity or 16,25+7,5=23,75m free cash
to the firm. Overall equity value should increase to 237.5m.

b. How much will the activist shareholder make from his operation if he sells the shares at the
new price?

He makes 20% of 37.5m=7.5m

c. A mutual fund has a more modest proposal. He thinks that top management should be given 1
million stock options with a strike price of $20. How much will the management earn on
these stock options if as a consequence they eliminate all inefficiencies?

Full firm value is 400m, however, in this case all stock options will be exercised. This
provides the company with a cash injection of $20*1m=$20m leading to a fully diluted stock
price of 420/11=38.18. The management will make 38.18-20=18.18 per option or 18.18
million overall.
In reality management will not have incentives to eliminate all inefficiencies because they
only capture about 10% of the value of these perks through the increase in stock option
value.

Prof. Michael Troege, ESCP Europe

Advanced Corporate Finance 2019/20

d. What are other possibilities to decrease the Agency conflict between managers and
shareholders and increase the firm value?
Many possibilities: 1. reduction of asymmetric information, i.e. introduction of external
board members or shareholders owning a large fraction of the capital. 2. Different forms of
incentive contracts: Bonus payments, vested (i.e. non sellable) stock for the management etc.

Prof. Michael Troege, ESCP Europe