Question
A long time ago, Teldar Paper was owned and managed by Mr. Cromwell, Teldars founder and current C.E.O. Now it is a publicly traded company.
A long time ago, Teldar Paper was owned and managed by Mr. Cromwell, Teldars founder and current C.E.O. Now it is a publicly traded company. The earnings of the firm this year will either be 1,200 or 800, depending on the state of the economy. State prices are . Mr. Cromwell has access to a corporate jet (paid for by Teldar Paper) and can use it as follows:
Purpose of Jet | Cost | Value to Mr. Cromwell |
---|---|---|
Transport Board of Directors | 400 | 250 |
Transport C.E.O. | 100 | 120 |
Transport C.E.O.'s pet dog | 200 | 160 |
If he has personal access to the jet, he can do business more efficiently. If the board members also have access, they can conduct meetings on the golf course in Palm Springs not so efficient, but good for team spirit. If the C.E.O.s dog gets a plane ride too (its a purebred), Mr. Cromwell saves on the kennel fees. He can elect to use the jet for all, none, or any combination of these purposes.
a) Pretend Mr. Cromwell is still the sole owner. He owns 100% of the equity of the firm. What would be his optimal use of the corporate jet? Consider how the value of Mr. Cromwells shares will change with each plane ride along with his personal benefit. b) Now consider how Mr. Cromwell would allocate the use of the corporate jet right after the IPO when he issued shares amounting to 25% outside equity. Now he owns only 75% of the value of the firm. Compare the resulting value of the firm with that in part (a) to calculate the agency cost of 25% outside equity. That is, calculate the difference between the value of the firm under this option with the case of full ownership.
c) Finally, consider what the C.E.O. would do now that he is running the publicly traded company but has only a 10% stake. Calculate the agency cost of 90% outside equity.
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