The agency cost of overvalued equity and the current state of corporate finance

My intention today is to provide a way to understand some of what’s currently happening in the world of finance and corporate governance at this time (June 2002). Few if any of us have discussed with our students the consequences of a company’s stock price becoming overvalued. Indeed I know of nowhere in the finance literature where the problems associated with overvaluation are discussed. We talked for a long time in the 1980s about the effects of under-valuation, and I will have a little to say about that below. But as things have progressed over the last half-dozen years over-valuation has come increasingly to occupy my thoughts. Indeed, understanding the incentive and organisational effects of stock overvalua-tion will help us understand much about the current malaise in corporate finance and corporate governance that surrounds the events at Enron, WorldCom, Xerox, and many other companies. I will review this situation briefly, and then move on to consider the agency costs of undervalued and overvalued equity. For the most part I’m going to concentrate on the latter, and examine the necessity for managers to manage stock prices down in situations where they become substantially overvalued