Reducing the costs of managerial discretion?

[danielkan2000]

on Book 1 Study note page 48/60, you mentioned that the company can borrow against assets rather than against future project in order to reduce the cost of managerial discretion?

What does that mean?

 

[David Harper CFA FRM]

Hi Daniel,

Right, agree, that's a bad (nonsensical, really) paraphrase of, in turn, a convulted point by Stulz. His point seems to be:

risk management reduces agency cost

....because risk management "preserves ongoing firm value and hence might enable....[the firm] to borrow against assets rather than try to borrow against future projects" with the implication that reducing firm value variablility (i) enables easier borrowing against assets (as opposed to project-based borrowing) and (ii) by decreasing variability due to unexpected losses, increases investor transparency into management's ability.

So, the argument seems to hinge on the idea that agency cost of managerial discretion is an additional premium levied by investors; i.e., if they are unsure, they want more return. But i think he's saying: risk management gives the firm an alternative (i.e., borrowing against assets) that presumably *avoids* the agency cost associated with project-based financing.

David