4.2. THE RISK SHIFTING PROBLEM effects of debt. If a firm takes on a lot of debt the managers will be forced to work hard. Jensen(1986) also emphasized the incentive aspects of debt in his famous"free cash Hlow "theory. If managers have access to large amounts of funds, i.e. free cash How, they may use it to pursue their own interests rather than the shareholders. One way the shareholders can prevent this is for the firm to take on a lot of debt. Easterbrook(1984)pointed to the incentive effects of dividends. If managers pay out a large amount in dividends they will be unable to waste the funds pursuing their own interests The jensen and Meckling article also lead to a consideration of how the nanagers' incentives could be aligned with those of the shareholders through executive compensation. There is a large literature on executive compensa- tion which is summarized in Murphy(1998 Finally, there is also a large literature justifying debt as an optimal con- tract which uses an agency approach. The three pioneering papers in this lit- erature are Townsend(1979), Diamond(1984)and Gale and Hellwig(1985) In this chapter we will cover the following applications of agency the to corporate finance The risk shifting problem · Debt overhang Debt and equity as incentive devices Executive compensation Debt as an optimal contract 4.2 The Risk Shifting Problem As discussed in the Introduction one of the most important conflicts of inter- est between equityholders and bondholders is that if managers act in equity holders' interest they may accept negative NPV investments at the expense of bondholders The basic idea is the following. Suppose a firm has $1,000 in cash the day before its debt, which has a face value of $5,000, comes due. If the equityholders(or the managers acting on their behalf) do nothing then the firm will go bankrupt and they will get nothing. What should they do? Suppose the equityholders took the cash and went to Atlantic City. If they4.2. THE RISK SHIFTING PROBLEM 3 effects of debt. If a firm takes on a lot of debt the managers will be forced to work hard. Jensen (1986) also emphasized the incentive aspects of debt in his famous “free cash flow” theory. If managers have access to large amounts of funds, i.e. free cash flow, they may use it to pursue their own interests rather than the shareholders’. One way the shareholders can prevent this is for the firm to take on a lot of debt. Easterbrook (1984) pointed to the incentive effects of dividends. If managers pay out a large amount in dividends they will be unable to waste the funds pursuing their own interests. The Jensen and Meckling article also lead to a consideration of how the managers’ incentives could be aligned with those of the shareholders through executive compensation. There is a large literature on executive compensa￾tion which is summarized in Murphy (1998). Finally, there is also a large literature justifying debt as an optimal con￾tract which uses an agency approach. The three pioneering papers in this lit￾erature are Townsend (1979), Diamond (1984) and Gale and Hellwig (1985). In this chapter we will cover the following applications of agency theory to corporate finance. • The risk shifting problem. • Debt overhang. • Debt and equity as incentive devices. • Executive compensation. • Debt as an optimal contract. 4.2 The Risk Shifting Problem As discussed in the Introduction one of the most important conflicts of inter￾est between equityholders and bondholders is that if managers act in equity￾holders’ interest they may accept negative NPV investments at the expense of bondholders. The basic idea is the following. Suppose a firm has $1,000 in cash the day before its debt, which has a face value of $5,000, comes due. If the equityholders (or the managers acting on their behalf) do nothing then the firm will go bankrupt and they will get nothing. What should they do? Suppose the equityholders took the cash and went to Atlantic City. If they