1. The Structural Agency Solution to Determine Going Concern Status 黃佳婷 黃怡嘉 2009/05/22 1

2. Outline Introduction Structural Agency Problem The Agency Cost The Going Concern Decision Case Study: Lucent Technologies Inc. Conclusion 2

3. Introduction This paper presents a positive theory to determine a firm’s going-concern for auditing Structural agency problem – the different maturity structure of the debt and – insufficient asset value (=‘negative equity value’) Using an option-theoretic approach – in a multi-period setting 3

4. Outline Introduction Structural Agency Problem The Agency Cost The Going Concern Decision Case Study: Lucent Technologies Inc. Conclusion 4

5. Structural Agency Problem 1. 有能力支付下期的 debt payment 2. 繼續控制公司 3. 逃避 default Assets < DebtsDefault An agency problem occurs Share holdersDebt holders 1. 沒有權力去查帳 2. 無法限制股東賣資產 1. 無法發新股票 2. 無法發新債 5

6. Structural Agency Problem 償債方式：發新股票、發新債、賣資產 …. Geske (1977) – 假設沒有 structural agency problem – a multi-period capital structure model under the Black- Scholes assumptions – 償債方式：發新股票 – 無法發新股票等同於 default 這篇論文 – 假設有 structural agency problem – 從兩種不同的假設計算 agency cost 6

7. Structural Agency Problem A simple numerical example – Two zero coupon debts one and two years to maturity both are $100 face value – t = 0 – the risk free rate is about 10% 7 230

8. Structural Agency Problem t = 1 the asset grows to $450 Geske (1977) the firm should raise equity to pay for the first debt raise equity 8

9. Structural Agency Problem t = 1 the asset drops to $150 the second debt is priced at $75 – due to higher risk the new equity owner pays $100 in cash but in return receives a portion of $75 raise equity 9

10. Structural Agency Problem t = 1 the asset drops to $150 the second debt is priced at $75 – due to higher risk the new equity owner pays $100 in cash but in return receives a portion of $75 The firm should not be considered a going concern! raise equity 10 The firm cannot raise equity !

11. Structural Agency Problem t = 1 The (break- even) asset value is falls to $186.01 The second debt is worth $86 The default point is $186 raise equity 11

12. Structural Agency Problem The relationships between the market value of debt (two- year debt at year 1) and market value of asset in previous examples. raise equity 12

13. Structural Agency Problem t = 1 The default point is $186 Selling assets cause the second debt to drop the equity immediately has an option value at the cost of the remaining debt sell assets 13

14. Structural Agency Problem new debt t = 1 The default point is $186 The principal of the new debt can be extremely high It should not matter if the funds come from new equity or new debt at just over break-even point 14

15. Structural Agency Problem Companies will receive a going concern opinion at $186 – breakeven point using the Geske Model (1977) – The firm cannot raise equity at $150 – the firm cannot raise equity – sell assets to pay the senior debt – the junior debt will be worth less than $50 – The transferring of wealth from debt owner to equity owner is what we define as the agency problem 15

16. Structural Agency Problem Figure 2 gives a plot of the equity value versus asset value for the example of 186 breakeven point at time 1 of $186 using the Geske Model (1977). 16

17. Structural Agency Problem Figure 3: Default Difference and the Cause of Agency Problem 17 186 150100 Using the Geske Model (1977)

18. Structural Agency Problem Geske (1977) model – at the due date of the first debt, the company faces a decision whether to pay the coupon – if the company decides to pay, the company continues to survive much like exercising the compound option to keep the option alive – The company’s survival criterion whether the company can raise new equity capital the market value of the assets must stay above the market value of the liabilities at the moment of the coupon. 18

19. Outline Introduction Structural Agency Problem The Agency Cost The Going Concern Decision Case Study: Lucent Technologies Inc. Conclusion 19

20. The Agency Cost A model of the structural agency problem in a two-period Geske framework – The way that immediate debt payments can be paid: Excess liquidity Selling assets – K i : coupon at t=i – A i : the total asset value at t=I

21. The Agency Cost At t=1 – Asset value r : risk free rate, σ : volatility, W t : the Wiener process – Equity value where

22. The Agency Cost At t=1 – Debt value – Balance table Before CouponAfter Coupon Equity Debt Total Asset

23. The Agency Cost At t=1 – Default condition – Critical asset value E 1 -K 1 =0 The default point for the firm

24. The Agency Cost Under Credit Risk – The firm can continue to operate when E 1 < K 1 < A 1 – The conceptual equity value is negative Creates the agency problem

25. The Agency Cost Equity value where A 1 > K 1 A 1 ≦ K 1 A 1 > K 1 A 1 ≦ K 1

26. The Agency Cost Agency cost

27. The Agency Cost The n-period Agency Model – Between any two coupon periods we divide the state space into k+1 partitions –,,, – At maturity ( ), for all j –, where

28. The Agency Cost Equity value with agency cost – At maturity, –,where and

29. The Agency Cost The payoffs at T n-1 debt expiring at n-1=K n-1 – A n-1 > K n-1 debt expiring at n=present value of present value of debt expiring at n-1=A n-1 – A n-1 ≤ K n-1 debt expiring at

30. Outline Introduction Structural Agency Problem The Agency Cost The Going Concern Decision Case Study: Lucent Technologies Inc. Conclusion 30

31. The Going Concern Decision Characteristic of the model – The structural agency problem results from K 1 and – is define as “should be default point” –, and as the asset value increases, AC approaches zero – The max agency cost always happen at – Default barrier

32. The Going Concern Decision The “going concern index” – MAC: the max agency cost, appears at

33. Outline Introduction Structural Agency Problem The Agency Cost The Going Concern Decision Case Study: Lucent Technologies Inc. Conclusion 33

34. Case Study: Lucent Technologies Inc. Lucent’s trouble began in late 1999 as their stock price fell sharply and debt mounted The Lucent scandal coincided with the internet burst in 2000 – These two figures show that the overall market losses were less than Lucent’s losses after the burst of the internet bubble

35. Case Study: Lucent Technologies Inc.

36. Under pressure to meet revenue goals, Lucent in 1999 began to give large discounts to meet projected sales numbers and began extending more credit to service providers to win their business The company could no longer artificially inflate its earnings, and the company started to crumble

37. Case Study: Lucent Technologies Inc. The board took action and fired CEO Moreover as related to our agency costs, from 2001 to 2003 Lucent started to sell their assets and cut their work force to avoid default

38. Case Study: Lucent Technologies Inc. The agency problems with Lucent are not significant from 1997 to 2000 The agency problem starts to grow as their financial deteriorates sharply in 2001 In these two years the asset values are all below the implied default point making the equity E measures all equal to 0

39. Outline Introduction Structural Agency Problem The Agency Cost The Going Concern Decision Case Study: Lucent Technologies Inc. Conclusion 39

40. Conclusion The nontraditional, structural agency problem is the major consideration in firms that can no longer operate as going concerns A cut-off rule for those firms that we feel should not receive a clean audit per their going concern status – use Geske’s rule (1977) to correctly measure for insolvency under no agency problem conditions – derive a model under the existence of the agency problem Take Lucent Technology as an example 40