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

.Jensen, Michael C. and William H. Meckling, “Theory of the Firm:  Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics, Vol 3, No 4 (1976), 305-360.

Purpose:  To show how agency costs influence the firm’s ownership structure.

Agency costs are the sum of:

  • Monitoring costs incurred by the principal
  • Bonding costs incurred by the agent (costs incurred by the manager to guarantee or to prove his fidelity)
  • The residual loss (monitoring and bonding cannot usually prevent all agency-related problems)

This paper takes a positive approach, seeking to explain contracting methods rather than recommend methods.

A “firm” is a nexus of contracts between individuals, rather than a cohesive body with clear boundaries.  Therefore, firm behavior, like market behavior, is an equilibrium outcome.

Agency costs of outside equity:

  • If an owner-manager sells a fraction of the firm, his incentive to maximize firm value declines and he will increase his perquisites, thus reducing firm value.
  • In a rational market, equity purchasers of X% of the firm will only pay X times the value they expect the firm to have once the manager increases his perquisites.
  • Firm value is lower after a sale of equity, and since the outside buyer paid a fair price given the expected reduction in firm value, the loss of wealth is entirely imposed on the owner-manager who sold the equity.
  • The manager may be forced to sell equity to raise money for investment, but his total welfare may still increase if the investment is profitable enough.
  • monitoring and bonding can increase firm value and manager wealth regardless of who (principal or agent) incurs the costs.

Agency costs of debt:

  • Consider two investments requiring the same outlay, but with different payoffs and probabilities of success.
  • The high-variance investment, with a higher expected payoff but a lower probability of success, imposes risk on the bondholders.
  • A manager can increase his wealth by promising to invest in the low-variance project, selling bonds, and subsequently investing in the high-variance project.
  • In a rational market, bondholders will expect the manager to do this, so they will not pay the full (low-variance project) price for the bonds.
  • If the manager could fully self-finance, he would choose the high-variance project.
  • If the manager cannot finance the project and must sell bonds, then the bond buyers will not pay enough to finance the high-variance project.  The agency costs are the loss of value associated with forgoing the higher-expected-value project.
  • Monitoring costs (external audits, bond covenants, etc) can sometimes put a burden on the firm.
  • If the manager can produce information for monitors more cheaply than the monitors themselves (having internally collected data simply certified by external auditors), it will be worth it to do so.  This is referred to as bonding.
  • Bankruptcy costs and reorganization costs may also be incurred if the firm cannot meet its debt obligations.

Conclusions:

  • Managers want to spend a lot of money on perks.
  • higher leverage means managers’ equity forms a larger part of the whole, so managers’ incentives are more aligned with shareholders.
  • If all outside financing is debt, or if all is equity, agency costs one way or the other will likely be too high; there is a balancing point.
  • Inside vs. Outside Financing:
    • Inside financing avoids agency costs, but limits the manager’s ability to diversify his personal investments and limits the size of projects he can undertake.
    • Outside financing is often necessary to raise the capital needed for an investment.
    • Outside financing is often preferred by a risk-averse manager who wishes to diversify.