Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure

Jensen, M. and Meckling, W. 1976.Journal of Financial Economics

Ishva Minefee

September 25, 2012

Overview of Presentation

• Study’s Motivation

• Literature Background

• Notions of the ‘Firm’

• Agency Costs Scenarios: Outside Equity and Debt

• Theory of Corporate Ownership Structure

• Extension of the Analysis

Study’s Motivation

• Objective of the article is to “develop a theory of ownership structure for the firm” (p. 305)• Extant ties to transaction cost economics

• Authors draw from theories on (1) property rights, (2) agency, and (3) finance

• Explanations of proposed theory include• Why managers choose activities that potentially decrease the value

of the firm• Why managers fail to maximize value, yet remain efficient

• Authors argue that previous literature posits a theory of the market, rather than a theory of the firm

Literature Background: Property Rights

• Specification of individual rights determines how costs and rewards will be allocated among organizational participants

• Significance of implicit and explicit contracting for specification of individual rights

• Individual behavior in organization depends on the nature of contracts

Literature Background: Agency

• Agency relationship defined as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent” (p. 308)• “Separation of ownership and control”

• In “cooperative effort” situations, the agency costs are:• Monitoring expenditures by the principal• Bonding expenditures by the agent• Residual loss (e.g., welfare reduction for principal)

• Agency costs may result from opportunistic behavior or shirking (Alchian and Demsetz, 1972)

Notions of the ‘Firm’

• Coase (1937): Boundary of the firm is the ‘range of exchanges over which the market system is suppressed and resource allocation is accomplished by authority and direction’

• Alchian and Demsetz (1972): Emphasis on role of ‘contracts as a vehicle of voluntary exchange’

• Authors’ definition of the firm:• “A form of legal fiction which serves as a nexus of contracting

relationships and which is also characterized by the existence of divisible residual claims on the assets and cash flows of the organization which can generally be sold without permission of the other contracting individuals” (p. 311)

Agency Costs: Outside Equity

• In a wholly owned firm, decisions are made to maximize utility (pecuniary and non-pecuniary benefits)

• The inclusion of outside equity will generate agency costs due to divergence of interests • Increase in monitoring costs • Owner-manager will try to increase non-pecuniary benefits

• Assumptions in formal analysis

Outside Equity: Scenario

Outside Equity: Summary

• Expectations to observe both bonding and external monitoring activities. The level of these activities will satisfy conditions of efficiency

• Agency costs are a function of

• Monitoring and bonding activities • Competition • Manager’s preference for non-pecuniary benefits

Agency Costs: Debt

• Why are diffuse-ownership organizational forms prevalent, when sole owner can incur debt?

• Incentivized effects: Issuance of debt generates agency costs, which are the responsibility of the owner-manager

• Monitoring and bonding costs• Manager is likely to incur bonding costs to reduce effects of

internal and external monitoring costs

• Bankruptcy costs• Operating costs and revenues of a firm are adversely affected

Determination of the optimal ratio of outside equity to debt

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Lowest Agency cost

Theory of Ownership Structure Summary

• Integration of concepts from agency costs associated with outside claims on the firm

• Theory will determine• Inside equity (held by the manager)• Outside equity• Debt • Optimal size of the firm

• Optimal financing scenarios • E.g. proportion of outside equity is optimal (for a given level of internal equity)

when it results in minimum total agency costs

• Authors hypothesize that larger firms will incur more agency costs

• Owner-managers engage in diversification due to risk aversion and optimal portfolio selection

Extensions of Analysis

• Voting rights of outside shareholders and bondholders and their implications on owner-manager’s welfare

• Forwarded analysis included non-voting rights

• Analysis did not include role of previous debt held by owner-manager

• Expectation that monitoring would become specialized to institutions and individuals who possess comparative advantages in such activities

• Conversely, expectation of specialization of low agency cost financing arrangements

Conclusion

• “Level of agency costs depends on…common law and human ingenuity in devising contracts”• Foundation of authors’ arguments

• Authors focus on the ‘firm’• Despite inherent agency costs, creditors and investors accepted

the corporate form (at the time of writing)

• In what ways does analysis apply to other organizational forms?