Do Differing Attitudes Towards Risk Contribute to Cooperative Agency Costs of Debt

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Do Differing Attitudes Towards Risk Contribute to
Cooperative Agency Costs of Debt?

• Getu Hailu
• Scott Jeffrey
• Ellen Goddard

Symposium 2004 Cooperative Program in
Agricultural Marketing and Business June 2nd,
2004
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(No Transcript)
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Outline

• Background
• Part I Agency Costs of Debt
• Part II Decision Makers Risk Attitudes

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Do co-operatives have a significant economic
impact in Canada ?

• gt 1,000 agriculture based co-operatives in Canada
  (2001)
• In 2001 the Top 50 Co-ops employed about 2.5
  million people (8).
• Current situation
• Increased capital investment needs to be financed
• Co-operative agribusinesses and Capital
  Constraints
• Equity capital (members equity, unallocated
  equity)
• Debt capital (borrowing)

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What Happened?

• 1. Excessive borrowing (D/Egtgt1)
• 2. Demutualization
• 3. Sales to/Alliance with IOFs

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Long term Debt-Equity Ratio (CO-OP vs. IFO)
Maple Leaf Foods
Lilydale Foods
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ROE (COOP vs. IOF)
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Brief Summary of the 1990s Evolution

• 1992 UGG Demutualization
• 1996 SWP partial demutualization
• 1998 MWE AWP merger
• 2001 Agrifood International was sold
• 2001 Agricore United became part of a private
  company
• 2003/4 Ponoka Co-op

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So What?

• Some co-operative agribusiness firms are going
  out of business or changing their business model
  due partially to pressure to make investments to
  produce economies of scale.
• Who Cares?
• In some cases this is leading to increased
  concentration in the agribusiness sector.
• Traditional co-operative members may lose their
  equity.

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Is there a Problem with Debt Financing? Does
Capital Structure Matter?

• No, if the capital market is perfect, capital
  structure doesnt matter (M-M)
• Yes, asymmetry of information
• The costs related to differing incentives are
  often referred to as agency costs.
• Yes, corporate income tax
• The benefits related to corporate income tax (tax
  subsidy)

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Principal-Agent Problem

• Do the firms manager(s) and the owner of the firm
  have the same objectives?
• Usually not!
• The firms owners want to make profits.
• Manager(s) usually want to maximize their benefit
  from working (i.e. their wage less the time and
  effort required to get that wage).
• The difference between the firm managers goals
  and those of the owners creates what is called a
  principal-agent problem
• Assumption risk-averse manager and risk-neutral
  member!!

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What are Agency Costs?

• The concept of agency costs are meant to include
• the costs of mitigation of the problems (e.g.,
  monitoring costs).
• the welfare loss due to inefficient resource
  allocation.
• In short, agency costs are the difference
  between the first best solution under symmetric
  information and the second best under asymmetric
  information.
• It is possible to minimize agency costs, but it
  is not possible to eliminate them altogether.

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What are Agency Costs of Debt?

• It can be established that managers behave
  differently given different capital structures.
• Arises as the leverage of the firm increases
• Incentive to over-invest by managers (Jensen and
  Mackeling, 1976) leading to inefficiency of
  resource use.
• Under co-op situation, these problems may be more
  important as the managers compensation may not
  be tied to equity-based incentive mechanism.

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Debt Leverage and Efficiency

• BUT increase in debt leverage may increase
  efficiency of resource uses Jensen (1986).
• debt servicing obligations help to discourage
  overinvestment of free cash flow
• Open empirical question for co-op agribusiness
  firms?

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Similar Studies in the U.S.
Impacts of a 10 increase in debt

• In all previous studies, the agency costs of debt
  are investigated for aggregated data.
• This study examines the agency costs of debt case
  by case to take into account the differences
  across firms.

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Intractability and Testing for Agency Costs of
Debt

• The agency costs of debt are not easily tractable
  and testable.
• In an attempt to deal with an intractable problem
  the agency costs of debt are defined as follows
• agency costs of debt represent a shift in the
  production function through the impact on
  managerial efforts.
• Thus, there exists a stable relationship between
  output, inputs and pre-existing debt.

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Duality
From the economic theory Financial theory
(Brander and Spencer, 1989) The dual cost
function is
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Agency Cost Measurement

• Measure and test the agency cost related to debt
  capital

Agency problem
Marginal cost
Altered Incentive
If ACigt 0, and statistically significant,
then there is agency cost of debt, and hence
excessive debt leads to cost inefficiency. If
ACilt 0, and statistically significant, then debt
improves efficiency of resource use.
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Does Supply Management Matter?
A policy of limiting total production and imports
through the allocation of marketing rights, or
quotas. Invoking Envelope Theorem
Then, agency costs of debt are lower if there is
regulatory constraint on raw material supply.
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Does Governance Structure Matter?

• Good co-operative governance
• lower probability of information asymmetry
• altered incentive effect will be negligible

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Case Co-operative Agribusiness Firms
For the results of the analysis to be meaningful
firms with different situations should be
examined.

• Alberta Honey Producers Co-op - Unregulated raw
  material
• processes and packages pure natural honey and
  honey related products
• Lilydale Poultry Co-op - Regulated raw material
• Primary processing, Further processing, Hatchery
  operation
• Federated Co-operative - Wholesaling Co-operative
  
• petroleum retailing, family fashions, feed, food,
  forest products, and hardware and building
  products

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How Big are the Case Co-ops?
Source Agriculture and Agri-Food Canada
http//www.agr.gc.ca/cb/news/2002/n21213ae.html
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Data

• Individual co-op annual financial reports
• Output, variable cost, long-term debt, capital
  stock, variable input expenditures,
• CANSIM (Statistics Canada Database)
• CPI, raw honey price, container price index,
  interest rate
• The Annual Survey of Manufacturers (ASM
  Statistics Canada)
• Wage rates, poultry raw material prices
• Agriculture and Agri-Food Canada
• Poultry raw material price, poultry wholesale
  price

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CAPINV and Debt/Equity-Alberta Honey Producer
Co-operative
Capital Investment
Debt-to-Equity
?0.096
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CAPINV and Debt/Equity-Lilydale Poultry
Co-operative
Capital Investment
Debt-to-Equity
?0.38
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CAPINV and Debt/Equity- Federated Co-op
Capital Investment
Debt-to-Equity
? -0.437
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Elasticities Alberta Honey Producer Co-operative
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Elasticities Lilydale Poultry Co-operative
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Elasticities Federated Co-operative
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Agency Costs Elasticity (1975/85/2001/mean)
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What Does the Alberta H.P.C. Board Say?

• It is evident that we are not yet totally
  efficient in our management and organization...
• -Chairman of the Board (Alberta Honey Producers
  Co-operative Limited, Annual Report 2002 3)

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Does Supply Management Really Help Overcome the
Incentive Incompatibility Problem?

• ...within the industry, supply of product to
  processing plants is governed by national and
  provincial boards that directly impact quantities
  and live prices. As a result, the Co-operative
  only has control over the efficiency of its
  operations, which is a much smaller component of
  the total cost of merchandise soldi.e., total
  variable costs
• (LILYDALE, Annual Report 2002 28).

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Does co-op Structure Have Implications for Agency
Costs of Debt?

• Federated Co-operatives Ltd. conscientiously
  breathes life into the co-operative principles in
  its governance. Member co-ops are supported by
  courses in human resources, financial services,
  member relations, etc. (CCA. Autumn 2002. Those
  Things We Stand For http//www.coopscanada.coop/N
  ewsLetter/Governance/.)
• Management has control over much smaller
  component of the total cost of goods sold to
  members.

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Concluding Remarks

• Capital structure may matter in firms decision
  making.
• The degree of agency costs of debt may depend on
  the regulatory environment.
• Good corporate governance may mitigate the agency
  problem related to debt.
• When agency costs of debt are present, agency
  cost adjusted discount rate may be appropriate
  for capital investment decision making.
• If the agency costs of debt exist BUT are not
  included in decision making, it may lead to an
  overestimation of the NET BENEFITS of capital
  investment.

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Part IIDo Decision Makers Debt Risk Attitude
Affect the Agency Costs of Debt?
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Agency Costs and Risk Attitudes

• Agency costs empirical results are based on the
  theoretical assumptions that managers are
  risk-averse and members are risk-neutral.
• Risk-averse managers are expected to borrow less
  as compared to risk-taking managers.
• Managers /directors degree of risk-aversion has
  important implication on the level of debt
  financing risk exposure
• Different attitudes will affect negotiations
  between directors and managers and potentially
  lead to conflict.

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Debt and Risk Attitudes

• Mathematically,

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Theory of Planned Behaviour

• Human behaviour/intentions are guided by
• Attitude towards the behaviour (debt)
• Subjective norm (perceived social pressure)
• Perceived behavioural control (ability to affect
  company decisions)

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Theory of Planned Behaviour

(Debt)
(?Debt)
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Empirical Model
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Demographic Characteristics

• N 24

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Age Categories of Respondents
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When making investment decisions, I am willing to
accept more risk to achieve higher returns and
reach member goals.
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In your opinion, could excessive debt financing
lead to serious financial risk in your company?
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During the next two years I will approve
additional borrowing to finance new investments
in the company.
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During the next two years additional investments
should be financed solely through equity.
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I intend to approve additional borrowing to
finance new investments in the company over the
next two years.
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Attitude towards Debt
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Subjective Norm
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Perceived Behavioural Control
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During the next two years I will approve
additional borrowing to finance new investments
in the company.
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During the next two years additional investments
should be financed solely through equity.
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Summary

• Attitude towards debt may have positive impacts
  on intentions to increase debt capital.
• Perceived social pressure to increase or not to
  increase debt capital had negative impacts on
  intention to increase debt.
• Decision makers perceptions of their ability to
  increase debt capital had negative impact on
  intention to increase debt capital.

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.. summary

• Sample managers had a lower intention to increase
  debt capital than directors.
• Age had a negative impact on intention to
  increase debt, attitude towards debt, subjective
  norm, and perceived behavioral control.
• Education had a positive impact on intention to
  increase debt capital.

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Preliminary Conclusion

• Decision makers attitude towards debt may affect
  corporate financial risk management policy.
• Differing attitudes towards increasing debt
  capital between managers and directors may
  increase agency cost problems.
• This may result in significant costs associated
  with resolving conflicts.

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Question?

• Does this result extend to larger sample of
  decision makers?
• Does the manager-board difference in attitude
  towards debt affect the success of the business?

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Acknowledgements

• We acknowledge the financial support of
  Cooperative Program in Agricultural Marketing and
  Business, Department of Rural Economy, University
  of Alberta