Solving the Multi-Period Agency Problem and Design of Corporate Securities
35 Pages Posted: 26 Feb 2007
Date Written: February 2007
This paper identifies and solves the multi-period agency problem. Overcoming the major weakness of traditional agency theory in a one period world, we adopt a multi-period option method to show adverse incentive problems with debt solving for the actual agency cost using compound options. It does not require asymmetric information as exists with current agency models. We find that firms can have debts greater than their asset value and continue to operate as long as current payments are being met. This situation creates an incentive for them to sell off their best assets that increases the risk of their remaining business and reduces survival. A major result of this model is to show why sinking funds actually increase a firm's agency costs explaining the demise of the traditional sinking fund over the last twenty years.
Keywords: multi-period agency problem, compound options, bankruptcy, sinking funds
JEL Classification: G33, G34
Suggested Citation: Suggested Citation