Genzyme Corporation sample essay
Genzyme has a tradition to be financed with equity. High equity ratio has advantages such as low agency costs related to debt, lower financial stress and more flexibility for management, which is especially crucial for start-up companies, such as in the early stage of Genzyme. However, besides losing the tax shield from debt, high equity financing leads to an increasingly diffused ownership, which would in turn causes problems such as shareholder – management principal – agent problem and asymmetric information problem. Principal – agent problem: As agent of the shareholder (principal), management should aim at maximizing shareholders’ value, i.e. the market value of the equity. However, management tends to serve its own interests. In order to make management act in line with the shareholders’ interest, agency costs of managerial incentives are induced. For Genzyme, to increase leverage is one way to reduce managerial incentives related agency costs. However, management generally does not prefer debt, since higher leverage implies higher risk for bankruptcy as financial distress increases with the leverage level. In order to mitigate this problem, Genzyme can try to offer compensation contracts which reflect compensation to the firm specific risks that managers are facing.
This will make sure management to act in line with shareholders’ interest. Beside principal – agent problem, low debt equity ratio can also cause high adverse selection cost induced by asymmetric information. Asymmetric information problem: the separation of ownership and control of the firm will lead to asymmetric information problem. Management obviously has more information than shareholders and often will not disclose certain crucial information about firm’s strategic plans or operations. This will naturally have impact on the market value of a public traded firm like Genzyme. With asymmetric information, the market value of the firm might not reflect the true value of the firm. The market value tends to reflect a pooling equilibrium, because of high adverse selection. Fully separating equilibrium can only be obtained through firm’s sending unique, powerful but costly signals to the market. Therefore, Genzyme Corporation faces high signaling cost related to adverse selection induced by asymmetric information problem. Debt again serves good to mitigate information asymmetry problem and to discipline management.
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