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THEORY OF THE FIRM: MANAGERIAL BEHAVIOR,

AGENCY COSTS AND OWNERSHIP STRUCTURE


BY JENSEN AND MECKLING, JFE, 1976

Present by Kamal Saeed


ID 571-9580
Objective of the paper
The paper integrates elements from the theory of agency,
theory of property rights and theory of ownership structure
of the firm defining agency cost showing its relationship
with separation and control issue. Nature of the agency
cost generate by existence of debt and outside equity

Who bear the cost of agency cost


Finding pecular and non pecular cost of agent
Whats the idea?
Agent = Manager
Principal = stock and debt holders
Agency problem applied to the firm.
Monitoring expenses by principal
Bonding expenditures by agent (such as insurance or financial
statements).
Residual loss (imperfect contracts)
Firms are legal fictions which serve as a nexus for series
of contracts.
Agency Costs of Outside Equity
Obviously, agency problem decreases as managerial
stock ownership increases.
Stockholders will pay less for equity to account for
monitoring and divergence costs.
As managerial stock ownership falls, stockholders will
want to monitor more.
As a side note: Free rider problem and effect of outside
block-holders.
Agency Costs of Outside Equity
VF when manager owns
100% no agency
problem. Slope = -1
(waste a dollar $1
dollar loss).
Owner sells (1-) of the
firm.
Buyer pays.?
V1P1 buyer pays too
much.
V2P2 buyer pays
right amount, assumes
manager will be at F.
Agency Costs of Outside Equity
Optimal firm size
OZBC when
owner can afford
project
OZED when
owner cannot
afford and must
finance w/equity.
Agency Costs of Outside Equity
Monitoring question
Indifferent between no
monitoring VBF and
monitoring VCF
(they say VCF)
M= D-C of cost.
Shareholders will have
to monitor & Owner-
manager reaps all
benefits in price of
claims
Agency Costs of Outside Equity
Monitoring and size
of firm.
Not much different
Monitoring does not
do much.
This not even that
important after
considering free
rider problem.
Monopolies have
same incentives
Agency Costs of Outside Equity
Limited liability as explanation for equity markets.
Without it, lower cost of debt, but higher cost of information and
monitoring for shareholders
No articulate answer explains why firms raise so much
money by selling equity.
Agency Costs of Debt
Risky borrowing can lead to success if project
goes well if not would account for bankruptcy
.
Two mutually exclusive project 1 and 2 if 2 is
riskier than 1 than owner would look for debt or
borrowing rather than using his own money if he
has to use his own money he would opt for
project 1.
Agency Costs of Debt
Again, 2 investment opportunities, 2 > 1
Firm issues debt
Stockholders have an option with exercise price = Bi
(i=1 or 2) for the firm.
Value of the option increases with volatility. Therefore,
stock holders prefer to pursue project 2. So B2 < B1 .
Bondholders will always assume firm will invest in
project 2. They will pay B2 for any bonds the firm issues.
Firms will thus have an incentive to invest in risky
projects they want to fund with debt.
Agency Costs of Debt
Bond covenants can be attached to debt issues
to prevent risky investments.
It is costly to write and enforce them. It also limits
management flexibility, which leads to lower
profits. Monitoring costs are borne by the owner.
Bondholders may also pay manager to write
reports because it is cheaper for manager to
provide information that manager is already
partially collecting bonding costs.
Other possible costs of debt bankruptcy
Agency Costs of Debt
As leverage rises, so does probability of bankruptcy.
Managers will have to be paid more. Contracts with
suppliers will have to be shorter term.
As leverage rises, option on firm goes more out of the
money agency costs of debt rise.
As equity rises, agency costs of equity rise.
Optimal Leverage
They recognize actual
shape of upper curve is
not known.
E* minimizes agency
costs.
2 levels of outside
financing.
In Comes Diversification
Manager does not
want all eggs in
one basket
Better to sell part of
firm and invest in
other assets.
Demand for
outside financing is
really high with
high managerial
ownership.
Conclusions
Agency costs should affect capital structure.
Agency costs exist between managers and shareholders,
and between bondholders and shareholders.
Agency costs of equity decrease with managerial
ownership.
Agency costs of debt increase as investment opportunities
increase.