Agency Cost Problems and the Arbitrage Process
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1. Explain why agency costs would probably be more of a problem for a large, publicly firm that uses both debt and equity than for a small, unleveraged, owner-managed firm.
2. Explain, verbally, how MM use the arbitrage process to prove the validity of Proposition I. Also list the major MM assumptions and explain why each of these assumptions is necessary in the arbitrage proof.
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The answer gives a solid paragraph for each question with a total of 397 words.
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1. First, let us understand what is agency cost. The costs associated to insure that the actions of the management are consistent with contractual agreements among management, stockholders, and debt-holders is called agency cost. This includes cost of monitoring, supervision, reviews, etc. Since, in case of a large, publicly owned firm the amount of monitoring required by the shareholders is more as compared to that for a small, unleveraged, owner-managed firm. Thus, shareholders' agency cost is higher for large publicly owned firm. From the point of view of debt-holders, the agency cost is same ...
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