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

Michael C.Jensen & William H. Meckling

lee yaeju

on 27 March 2012

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

Theory of the firm: Managerial Behavior, Agency Costs and Ownership Structure
Thank you for your attention!
is here
-The firm definite a black box
Definition-Theory of the firm
Definition- property rights
Michael C. Jensen & William H. Meckling
This is first paper that deal with ownership structure problem analyzed by the viewpoint of agency costs.

J&M treated agency costs by generating ownership structure and ownership structure maximizing firm value

Principal(stock and debt holders)’s objectives
≠ Agent(manager)’s objectives

Manager’s utility

Pecuniary aspects
by increasing the value of firm.
Aspects by expending firm’s resources
for his own consumption
-Theory of firm has been stimulated by the pioneering work of Coase, and extended by Alchian, Demsetz and others.

-Focus on the behavioral implications of the property rights specified in the contracts.

-Contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, and so on
-Firms are legal fictions which serve as a nexus for series of contracts.
More recently, debates over ‘social responsibility of corporations’ , ‘the separation of ownership’
Definition- Agency costs
1. Principal-Agent problem

Agent relationship: a contract under which one or more persons
(principal(s)) engage an other person(the agent)to perform
some service.

Principal’s behavior : limit agent’s interest by giving
appropriate incentives for the agent and by incurring monitoring
costs to limit the aberrant activities for the agent

Agent’s behavior: pay to expend resources(bonding costs) to
guarantee that he will not take actions which would harm the principal
Agency problem
Definition- Agency costs
2. Agency Costs

Agency costs: costs generated by the contractual arrangements between the owners and top management of the corporation.

The result of Agency Costs : decrease firm’s value

Agency problem applied to the firm.

Monitoring expenses by principal
Bonding expenditures by agent (such as insurance or financial statements).
Residual loss (owing to imperfect contracts)
Agency problem
Causes of the agency problem

1.Conflict between owner-manager and outside shareholders : non-pecuniary benefits, invest-ment problem, time definition problem

2. Conflict between debt holders and shareholders
: problem about dividend policy, problems caused by debt financing

3. Conflict between inside equity and outside equity : asymmetric information, excessive expenses
Introduction and Definition
The Agency Costs of Outside Equity
The Agency Costs of Debt
Optimal Ratio of Outside Equity to debt
B team
a secondary master’s course, Yae Ju Lee
a tertiary master’s course, Ki Hyun Lim
Agency Costs of Outside Equity
Manager owns 100% of the equity

max firm’s value =max manager’s wealth

Manager sells equity claims
Excessive expenses trade-off with stakeholders
generate agency costs

Agency costs of outside equity increase ,
a manager’s equity ratio was decreased

agency problem decreases as managerial stock ownership increases.
Owner sells parial equity of firm
VF : Budget constraints
V1P1 , V2P2 :Manager’s changed
budget constraint

VF manager owns 100%
no agency problem.
V*,F*,D when U2 on VF

Owner sells (1-a) of the firm.
V1P1 : outsider pays too much.
V2P2 : outsider pays right amount, assumes that manager will be at F’.

Manager’s utility: U1(V1P1) >U2(V2P2 )
Firm value : C(U2)>A(U1)>B(U3)
When No monitoring costs, optimal firm size
OZBC when owner can afford project (100%individual financing)

A : Increased agency costs

C: Investment for maximizing firm value.

D: Combination for maximizing manager’s wealth
Monitoring question
M: D~C ; optimal monitoring costs

C : optimum of monitoring (shareholder aspects) and bonding costs (manager aspects)

BCE curve : budget constraints when monitoring

manager’s non-pecuniary benefits(F)

Shareholders will have to monitor & Owner-manager reaps all benefits in price of claims
Monitoring and optimal size of firm.
Not much different
Monitoring does not do much.

ZC : manager owns 100%
ZD: partial ownership structure, no bonding cost (no monitoring cost)

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.

No articulate answer explains why firms raise so much money by selling equity.
Agency Costs of Outside Equity
Agency Costs of Debt
Given two projects, manager will promise to take the
safer project and then undertake the riskier project
(at the expense of the bondholders)

The agency costs of debt consist of

The opportunity wealth loss
caused by the impact of
debt on the investment decisions

The monitoring and bonding expenditures
( by the bondholders and the owner-manager)

The bankruptcy and reorganization costs
Two investment opportunities, σ2 > σ1

Firm issues debt
Stockholders have an option
Value of the option increases with volatility.
Therefore, stock holders prefer to pursue project 2 ( B2 < B1 )
Bondholders will assume that firm will invest in project 2.
They will pay B2

Thus firms will have an incentive to invest in risky projects
(project 2) they want to fund with debt.
Bonds can be attached to debt issues to prevent risky investments

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
When leverage rises, so does probability of bankruptcy.

Managers will have to be paid more.

As leverage rises, firm goes more out of the money agency costs of debt rise.

As equity rises, agency costs of equity rise.
They recognize actual shape of upper curve is not known.

2 levels of outside financing.

E* minimizes agency costs.
Optimal Ratio of Outside Equity to debt
Two different firm size, total agency costs concerning the outside financing

Firm size
V1* >V0*

Total agency costs

AT*[K,V1*] > AT*[K,V0*]
Better to sell part of firm and invest in other assets.

Demand for outside financing is really high with high managerial ownership.

Optimal fraction of firm financed by outside claims is K*

Manager does not want all eggs in one basket !!(portfolio)
Agency costs are as real as any other costs.

Agency costs should affect capital structure.

Agency costs exist between managers and
shareholders, and between bondholders and

Agency costs of equity decrease with
managerial ownership.

Agency costs of debt increase as investment opportunities increase.
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