Finance
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IntroductionThe aim of this paper is to explore the relationship between agency problem, research and development investment and firm value. The separation of ownership and control in a firm creates conflict of interest. If the owner and the manager of the firm is one person, s/he will her actions will be directed to the maximization of the value of the firm, because s/he knows that the gains from the value increase will add to her personal wealth. However, it is not case in large corporations. In those corporations, firm is owned by shareholders and managed by directors/managers. The managers are agents of the shareholders. They are appointed to their positions by the shareholders to run the firm. Their interests are not aligned with the interests of the shareholders. They have incentives to increase their wealth at the expense of shareholders’ (Lafond& Roychowdhury 2008).  Fortunately, there are ways thorough which it is possible reduce agency problem. One of the ways is to make managers shareholders of the firm in order to make them interested in value maximization. In such case, their interests to a great extent will overlap with that of owners’ (Ross et. al. 2002).  Second, concentration of ownership will also contribute to the reduction of agency cost. Big shareholders have more incentives, control and decision-making power and are more engaged in the affairs of the firm which would limit self-interested behaviour of the managers (Baysinger et. al. 1991) Third, agency cost can be mitigated by increasing debt ratio (Grossman&Hart 1982). Changes in the agency problem of a firm also affect the value of the in many ways, one of which is investment in research and development projects. Debt in the capital structure of a firm According to capital structure irrelevance principle by Modigliani and Miller (1958), the value of a firm is unaffected by the way firm is financed. It means that levered and unlevered firm has to be of the same value. Their proposition is valid only under some strict assumptions: no tax, no bankruptcy costs, no transaction costs, no information asymmetry. However, these conditions are not possible in real world. Existence of the abovementioned factors alters the capital structure.  Tax shield which protects interest payments from taxation gives a firm strong incentive to replace all equity in its capital structure with debt in order to benefit from the shield maximum (Modigliani&Miller 1963). The reason that prevents firm to finance its operations completely by debt is bankruptcy cost which rises with debt.  In real world bankruptcy cost might be considerably high and firms have to be careful in the choice of debt ratio.

The cost of financial distress is positively correlated with the level of debt in capital structure of a firm. When a firm is not able to pay for its obligations financial distress occurs. According to the trade-off theory of capital structure, the advantage of financing with debt includes the gains from the tax shield of debt, while the disadvantage consists of the costs of financial distress (bankruptcy costs of debt and non-bankruptcy costs). The firm has to find an optimal capital structure by balancing between tax saving benefits of debt and the cost of using debt (Ross et. al. 2002). The advantage of using debt for financing is not limited to tax saving. In the next part we look at the relations between debt and agency cost. Debt and agency costThe agents of the shareholder of a firm are the managers who are appointed by them have the responsibility to manage their business on behalf of them. Jensen and Meckling (1976) point out that the nature of relationship between managers and shareholders result in agency problem. Managers attempt to ensure higher salaries, better job security and other privileges for themselves which contradict with the interest of shareholders. Debt can serve an effective mechanism to lessen clash of interests between shareholders and managers. First, the free cash flow hypothesis claims that the interest payment reduce free cash flow and limits the ability of managers to engage in wasteful activity (Jensen 1986). “Firms with high free cash flow are more likely to make bad acquisitions than firms with low free cash flow” (Ross et. al. 2002). Low cash flow decreases the overinvestment problem. Second, debtholders who lend their funds to firms are deeply concerned with the activities of managers and constantly monitor them and pressure them to run the business profitable. As managers have discretion over free cash flow they might invest in negative present value project or in empire building (Jensen 1986). The empire building will make them more powerful and create higher salaries. Such behavior by managers will lead to overinvestment problem. They will have desire to invest even if the project does not benefit shareholders. The abundance of free cash flow can be controlled by issuing debt and paying periodic payment of interests and principal. The creditor have incentive to monitor operations of the corporation to guarantee smooth flow of interest and principal payments (Jensen Meckling 1976). Especially large creditors such as banks have enough resources and expertise to build a compressive monitoring over the corporations. Monitoring by creditors reduce the burden of monitoring by shareholders. In the framework of the free cash flow hypothesis, it should be mentioned that since dividends also reduce free cash flow, payment of dividends also decrease the ability of managers to waste money (Ross et. al. 2002)

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Firm Value And Free Cash Flow Hypothesis Claims. (July 13, 2021). Retrieved from https://www.freeessays.education/firm-value-and-free-cash-flow-hypothesis-claims-essay/