SARON PLC CASE STUDY

Saron plc Case Study

Saron plc Case Study

Introduction

Agency costs in Saron plc may make business fixed investment inefficient. However, Hubbard (1998) points out that there is very little empirical evidence on the effect of agency costs on the corporate investment, while a large body of literature examines the effect of asymmetric information on business fixed investments. We investigate the effect of agency costs on business fixed investment by observing the patterns of quarterly capital expenditure changes.

Agency Problem in Capital Budgeting and Capital Expenditures

Brealey and Myers (2000) list empire building as an agency problem in capital budgeting. Empire building is that other things being equal, managers prefer to run large businesses rather than small ones. 7 Taggart (1987) describes the typical capital budgeting procedure in which divisional managers initiate budget proposals and headquarters assign budgets for them. Harris and Harris, Stein (1997) and Scharfstein and Stein (1996) acknowledge the possibility that even though headquarters represent shareholders, headquarters allow over-investment in divisions to reduce managers' rent-seeking activities. Both headquarters and divisional managers prefer being in charge of larger Saron plc. When there is an initial capital spending limit for any division, the manager will request a larger amount knowing that the headquarters may allocate a compromised level of capital. Headquarters make decisions about allocating funds to individual or divisional managers based on the proposals by the managers. However, headquarters do not assign the maximum of what the managers request since they know that managers tend to exaggerate claims about the productivity of capital. Instead, headquarters impose capital spending limits on the managers. Jensen and Meckling (1976) also argue that budget restrictions are used as a way to control the behavior of the owner-manager when the owner-manager has a partial ownership and an incentive to expend resources in order to capture non-pecuniary benefits. To wit, capital budgeting literature argues that managers tend to request a higher budget under budget restrictions.

Recognizing that analysis of the investment decisions of Saron plc occupies a prominent place in research programs in corporate finance, Hubbard (1998) summarizes the principal findings of studies that have extended conventional models of business capital investment to incorporate a role for “financing constraints” in determining investment. If the capital market is perfect, corporate fixed investments should not be related to the internal cash flows of the firm. However, when insiders have information that outsiders do not have, the cost of internal capital is lower than the cost of external capital. 8 Therefore, corporate investments may depend on changes in net worth. Alternatively, when managerial and shareholders' incentives differ, managers may invest in non-value maximizing projects.9 Therefore, for Saron plc with high agency costs, investment is less likely to be correlated with the firm's growth opportunities.

Scharfstein (1997) reports that divisions with good investment opportunities invest less than their single segment stand-alone industry peers, while divisions with poor investment opportunities invest more than their stand-alone industry peers. Lamont, 1997. O. Lamont , Cash flow and investment: evidence from internal capital ...