Question

Company Y borrowed $3 million to finance an investment. The lender insisted on a debt covenant in the loan agreement, specifying that the ratio of total liabilities to total tangible assets not exceed 60%. Company Y’s ratio of total liabilities to total tangible assets was 60.2% for the current year before reflecting the cost of a new billboard construction. The manager of Company Y has an option to expense or capitalise the cost of billboard construction for the current year. If the cost of billboard construction were recognised as an asset, the ratio of total liabilities to total tangible assets would be reduced by 0.3%.

Required

(a) Referring to your lecture notes, discuss how a debt covenant can be used to reduce agency problems?

(b) Which option might the manager of Company Y choose to recognise the cost of new billboard construction? How would agency theory explain it?

Answer 1

Answer to Question (A):

Let us first understand what are Debt Covenants.

Debt Covenants are simply restrictions in the Debt Agreement between the lender and the borrower which aims to protect the interests of the lenders by imposing restrictions on the borrowers.

Let us now understand what are Agency problem.

Agency Problem refers to a conflict of interest that is inherent in any relationship where one party is expected to act in the best interests of the other party.

There are several variants of the Agency problems.Debt Covenants tend to deal with Agency Cost of Debt Problem.

Agency Cost Debt problem refers to the conflict of interest between the management of a company its bondholders(lenders) and its shareholders

.Bondholders are lenders to the company and hence will receive first consideration in case of liquidation of a company, while shareholders receive the last consideration in case of a liquidation of a company often they do not receive nothing in case of liquidation.On the other hand shareholders can enjoy unlimited benefits if any risky project becomes profitable, on the other hand bondholders do not line risks.This leads to conflict of interest.

Debt Covenants impose restrictions on the borrowing company thereby preventing it from taking on too much debt and hence protecting both bondholders and shareholders thereby reducing the conflict.

Debt Covenants protect the current bondholders by ensuring that the company does not take on too much debt and thereby face financial risk.On the other hand, it protects the shareholders also as larger interest payments (due to taking on too much debt) would reduce the net income of the company available to the shareholders.

Answer to Question(B):

The manager of Company Y would choose to recognize the cost of billboard construction as an asset.

Agency theory refers to a principle that is used in explaining and resolving the issues between the business principals( for example :shareholders)  and agents (for example:the management of the company)

According to Agency Theory: When a manager is faced with restrictive debt covenants : managers will prefer to use accounting policies that increases both profit as well as equity which reduces the risk of violating a debts contract as well as lowering the cost of raising  further finance.

Thus, in the above case the manager will go for capitalizing the cost of billboard expenses.Capitalizing the expenses will lead to reporting of more assets and subsequently more equity as compared to recording it as an expense.As given in the question this higher reported equity and assets will reduce the closeness to the restrictive debt covenants.(In this case by capitalizing the expenses the total liabilities to total tangible assets will reduce by 0.3% thus bringing the ratio of total assets to total liabilities almost equal to the restrictive debt covenant).