Theory Of The Firm: Managerial Behavior, Agency Costs And Ownership Structure.

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Theory Of The FirmManagerial Behavior, Agency
Costs And Ownership Structure.
Journal of Financial Economics

• Michael C. Jensen and William H. Meckling
  Received January 1976, revised version received
  July 1976

• U892621 ???
• U892643 ???
• U892662 ???

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Outline

1. Introduction
2. Assumption
3. Agency cost on equity
4. Agency cost on debt
5. Corporate ownership structure
6. Qualifications and extensions of the analysis
7. Conclusion

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Introduction
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Property right

• Property right is generally effected through
  contracting individual behavior in organizations.
  
• In this paper, we focus on the contract between
  the owner and the manager of the firm

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Agency cost

• Agency relationship is a contract under the
  principal engage the agent to perform service on
  their benefits which involves some decision
  making authority to the agent.
• Agency costs include,
• The monitoring expenditures by the principal
• The bonding expenditure by the agent
• The residual loss

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The definition of the firm

• The private corporation or firm is simply one
  form of legal fiction which serves as a nexus for
  contracting relationships
• legal fiction certain organizations to be
• treated as individuals
  
  

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II. Assumption
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Permanent assumption

• P.1 All taxes are zero
• P.2 No trade credit is available
• P.3 All outside equity shares are non-voting
• P.4 No outside complex financial claims,such as
• convertible bonds or warrants can be issued
• P.5 No outside owner gains utility other than
• through the wealth and the cash flow

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• P.6 All dynamic aspect of the multiperiod
• nature of the problem are ignored
• P.7 The managers wage are held constant
• throughout the analysis
• P.8 There exist a single manager with
• ownership interest in the firm

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Temporary assumption

• T.1 The size of the firm is fixed
• T.2 No monitoring or bonding activities are
• possible
• T.3 No debt financing through bond, preferred
• stock, or personal borrowing is possible
• T.4 All element of the managers decision
• problem included by the presence of
• uncertainty and the existence of
• diversifiable risk are ignored

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III. Agency cost on equity
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No monitoring cost Fixed the size of firm

• V value of the firm
• F managers expenditures on non- pecuniary
  benefit
• U indifference curve of the manager
• VF budget constraint
• ? fraction of managers equity

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V
FIRM VALUE AND WEALTH
D
V
A
U1
Slope -?
U2
B
V
U3
V0
Slope -?
Slope -1
F
F0
F
0
F
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• D optimal set between non-pecuniary and firm
  value
• B the final set when the fraction of outside
  equity is(1-?)
• V V ? V0 ? V
• F F ? F0 ? F

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Theorem

• For a claim on the firm of (1-?) the outsider
  will pay only (1-?)V when he expect the firm to
  have given the induced change in the behavior of
  the owner- manager.
• W S0 Si S0 ?V(F, ?)
• S0 ?V (1-?)V ?V
• V

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Determination of the optimal scale of the firm

• W initial pecuniary wealth
• I access to a project requiring
  investment outlay
• A the gross agency cost

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WV(I)-I
Expansion path with 100 ownership by manager
CURRENT DOLLARS
C
WV-I
A
D
WV-I
Slope -?
Expansion path with fractional ownership by
manager
F
F
Slope -1
MARKET VALUE OF THE STREAM OF MANAGERS
EXPENDITURESON NON-PECUNIARY BENEFITS
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• The managers indifference curve is tangent to a
  line with slope to -?
• The gross agency costs is equal to
• (V-I) (V-I) -? (F-F)
• ? ?V - ? I ? ?F 0
• ( since V V - F)
• ? (?V - ? I ) ( 1 - ? )?F 0

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The role of monitoring activities in reducing
agency cost

• M the optimal monitoring expenditure of the
  outside
• ( for this case distance between C D)
• BCE the opportunity set as the tradeoff
  constraint facing the owner
• V V F(M, ?) - M

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V
FIRM VALUE AND WEALTH
V
U1
D
M
C
V
U2
E
B
V
U3
Slope -?
Slope -1
F
F
0
F
F
MARKET VALUE OF MANAGERS EXPENDITURES ON
NON-PECUNIARY BENEFITS
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Expansion path with monitoring and bonding
activities

• P1 Expansion path with 100 ownership by
  manager
• P2 Expansion path with fractional
  managerial ownership but no monitoring or
  bonding activities
• P3 Expansion path with fractional
  managerial ownership and monitoring and
  bonding activities

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WV(I)-I
P1
CURRENT DOLLARS
C
P3
WV-I
G
v
WV-I
D
P2
F
F
F
F
MARKET VALUE OF THE STREAM OF MANAGERS
EXPENDITURESON NON-PECUNIARY BENEFITS
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• v W V I M
• M m b
• m cost of monitoring activities
• b cost of bonding activities
• A(m, b, ?, I) ( V - I ) ( V I M )

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IV. Agency cost on debt
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Three part of agency cost on debt

• The incentive effects associated with highly
  leveraged firms
• The monitoring and the bonding expenditures by
  the bondholders and the owner-manager
• Bankruptcy and reorganization costs

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The incentive effects

• The opportunity wealth loss caused by the impact
  of the debt on the
• investment decision of the firm.

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The incentive effects

• Bankruptcy behavior is the willingness of the
  residual claimant to engage in extremely high
  risk projects when there is no equity at stake.
• Under-investment is often find that new
  investment helps the bondholders at the
  stockholders expense

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The role of monitoring and bonding cost

• To limit the managerial behavior which results in
  reductions in the value of the bonds for the
  bondholders

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V.Corporate ownership structure
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Optimal ratio of outside equity and debt

• Si inside equity
• S0 outside equity
• B debt
• S S0 Si V S B
• E S0 / ( B S0 )
• As0(E) agency cost of outside equity
• AB(E) agency cost of debt
• AT(E) As0(E) AB(E)

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Agency cost(measured in unit of current cost)
AT(E) As0(E) AB(E)
A t (E)
As0(E)
AB(E)
1.0
E
0
E ( S0 / (B S0))
Fraction of outside financing obtained from equity
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Effects of the scale of outside financing

• K ( B S0 ) / V
• V the scale of the firm (constant)
• K i different level of outside financing
• K1 gt K2
• V1 gt V2

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• AT(E,K1)

High outside Financing
Total Agency cost
AB(E,K1)
As0(E,K1)
Low outside Financing
AT(E,K0)
As0(E,K0)
AB(E,K0)
E(K0)
E(K1)
1.0
Fraction of outside financing obtained from equity
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AT(E,K,V)
Total agency cost
AT(K,V1)
AT(K,V0)
0
K
Total agency costs as a function of the fraction
of the firm financed by outside claims for two
firm sizes, V1 gt V0
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Risk and the demand for outside financing

• The owner-manager will invest 100 of his
  personal wealth in the firm and then resort to
  outside financing but in fact he allocate his
  wealth in diversified ways to reduced the risk.
  So when he want to reduce this cost he will bear
  some agency cost( from the issuance of equity and
  debt)

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Marginal agency costs and marginal value of
diversification (measured in units in units of
current wealth)
Optimal amount of outside financing, K
?demand for outside financing
Marginal agency cost
? ?K
?
AT(E,K,V)
K
1.0
K
Fraction of firm financed by outside claims
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VI. Qualifications and extensions of the analysis
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Multiperiod and extension of the analysis

• Throughout our analysis we are dealing only with
  a single investment-financing decision and have
  ignored the future financing-investment
  decisions. If we take this into account it will
  have some changes such as the future sales of
  outside equity and debt, managers decision,
  agency cost and etc.

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The control problem and outside owners agency
costs

• We have assumed that all outside equity is
  nonvoting. If such equity have voting right, the
  manager will concern about the effects on his
  long-run welfare of losing effective control of
  the firm (the danger of being fired). So to
  determine an equilibrium distribution of outside
  equity is necessary.

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A note on the existence of inside debt and some
conjectures on the use of convertible financial
instruments

• Bi / Si B0 / S0
• Bi / Si gt B0 / S0
• Some other convertible securities such as
  warrants, convertible bonds, and convertible
  preferred stock

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Monitoring and the social product of security
analysts

• A large body of evidence exist which indicates
  that security prices incorporate in an unbiased
  manner all public available information and much
  of what might be called private information.
  Furthermore, the security analysis activities
  will reduce the agency costs associated with the
  separation of ownership and control they are
  indeed social productive.

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Specification in the use of debt and equity

• Our previous analysis of agency costs suggests at
  least one other testable hypothesis I.e., that
  in those industries where the incentive effects
  of outside equity and debt are widely different.
  The theory predicts the opposite would be true
  where the incentive effects of debt are large
  relative to the incentive effects of equity.

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VII. Conclusion