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.


  • 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.

Debt and Taxes

Miller, Merton H., “Debt and Taxes,” The Journal of Finance, Vol 32, No 2 (1977), 261-275.

Purpose:  To argue that, even if debt repayments are tax deductible, a firm’s value is independent of its capital structure.


  • The [potential] direct bankruptcy costs of debt seem too small to be balanced by the tax savings.
    • Corporations do not have as much debt as models suggest they should have – fear of bankruptcy has to be very high for debt levels in the models to match the empirical evidence.
    • The potential indirect costs of bankruptcy are probably not very big, either.
  • Between the 1920s and the 1950s, taxes increased 400% while corporate capital structures changed very little (and change through the end of the 1970s appears unlikely).
  • Investment bankers and corporate financial officers are aware of the tax implications of debt.
  • The only explanation left is that the tax savings of debt are much smaller than researchers generally believe.

Tax Advantages of Debt:

  • If there are no taxes, there are no tax advantages.
  • If there are corporate taxes but no personal income taxes, then the tax advantage of debt is the corporate tax rate multiplied by corporate debt.
  • If there are personal income taxes, and the personal tax on share income is less than the tax on bond income, then investors will prefer that corporations use equity financing over debt financing, thus negating the tax advantages of debt.
    • Corporations holding very little debt and/or paying small dividends will be preferred by shareholders in high tax brackets.
    • Corporations with high leverage and/or high dividends will be preferred by shareholders in low tax brackets.
    • One shareholder class is as good as another, so capital structure is, again, irrelevant.

The Cost of Capital, Corporation Finance, and the Theory of Investment

Modigliani, Franco, and Merton Miller, 1958, “The Cost of Capital, Corporation Finance, and the Theory of Investment,” The American Economic Review, Vol. 48, No. 3, 261-297.

Purpose:  This paper proposes a theory explaining how a firm’s stock price (market value) is impacted by managers’ capital structure decisions.

Motivation:  Previous work regarding the cost of capital treats assets as having known income streams, and adjusts for uncertainty simply by subtracting “risk discounts” from the expected rates of return.  This treatment of risk is inadequate.  A market-value approach—where the cost of capital is the return on an investment that does not affect a firm’s stock price—has promise, but we need a theory describing the impact of a firm’s capital structure on its market value.


  • Model 1:  Corporations can only issue common equity
    • Assume perfect markets, no agency problems, and an economy where all assets are owned by corporations that can only finance operations with common equity.  Therefore, the rate of return on one share equals expected return to the share divided by share price.
      • Since there are no agency problems, retained earnings are the same as cash dividends.
    • Assume classes of corporations where each share’s expected return is perfectly correlated with all others in the class.  Then there is one rate of return for each class, and all shares in a class are perfect substitutes (up to a scale factor).
  • Model 2:  Corporations can issue bonds in addition to common equity
    • Assume bonds trade in perfect markets and all corporations and households have a perfect credit rating.  Then all bonds are perfect substitutes (up to a scale factor), and have the same expected rate of return.
    • Market value is independent of capital structure.
      • If an individual values leverage, he can take it on himself by borrowing money to buy more stock in an unlevered company.
    • The expected rate of return on stock in a levered company is the rate of return on a pure-equity company from its same class, plus a premium equal to the debt-to-equity ratio times the spread between the class-specific equity return and the [universal] cost of debt.
  • Model 3:  Corporate interest payments are tax-deductible
    • The debt-vs-equity consideration is important for overall corporate liquidity management due to taxes, timing, market sentiment, investor tax profiles, etc.
    • However, all that matters in project financing is the cost of capital.  A preference for one type of financing over another does not make a project more or less profitable.

Empirical Evidence and Conclusion:

  • Using data from the only two relevant studies:
    • There is no significant relationship between leverage and cost of capital.
    • As leverage increases, expected return to equity increases.
  • The amount of leverage can be important over the life of a corporation, but is irrelevant in determining the profitability of a project.

The Cross-Section of Expected Stock Returns

Fama, Eugene F. and Kenneth R. French, 1992, “The Cross-Section of Expected Stock Returns,” The Journal of Finance 47 (2), 427-465.

Purpose:  This paper evaluates the joint effect of market beta, firm size, E/P ratio, leverage, and book-to-market equity in explaining the cross-section of average stock returns on NYSE, AMEX, and NASDAQ.

Findings:  Beta does not explain the cross-section of average returns.  Size and book-to-market equity each have explanative power both when used alone and in the presence of other variables.

Motivation:  The Sharpe, Lintner, and Black asset pricing model (beta) has been very influential, but there are notable exceptions to its premises.  Banz (1981) finds a significant size effect.  Bhandari (1988) finds a leverage effect.  Others have argued for effects of the book-to-market equity ratio and the earnings-to-price ratio.  Furthermore, Reinganum (1981) and Lakonishok and Shapiro (1986) find that the beta-return relationship disappears after 1963.


  • Data:  Nonfinancial NYSE, AMEX, and NASDAQ firms from 1962-1989
    • Monthly return data from CRSP
    • Annual accounting data from COMPUSTAT
  • Create portfolios based on size and pre-ranked beta (using trailing data)
  • Calculate the beta for each portfolio-year and assign it to each stock in that portfolio-year
  • Fama-MacBeth Regressions
    • Beta-size portfolios
      • For each month, for the entire cross-section, regress average return on beta, ln(ME), ln(BE/ME), ln(A/ME), ln(A/BE), and E/P
      • Sort stocks into 10 size deciles and then into 100 sub-deciles on “pre-ranking” beta
        • pre-ranking beta is each security’s beta for the 60 months prior to portfolio creation (requiring at least 24 months of data for inclusion in any portfolio)
        • Pre-ranking beta cutoffs are established using only NYSE stocks
    • Book-to-market portfolios and E/P portfolios
      • formed in a similar manner, with stocks sorted on either BE/ME or E/P
    • Size & book-to-market portfolios
      • Match accounting data for fiscal year-ends in calendar year t-1 to returns for the period starting in July of year t and ending in June of year t+1.
      • Use market equity in December of year t-1 to calculate leverage, book-to-market, and E/P ratios.
      • Use market equity in June of year t to measure size.
      • sort stocks into 10 market equity deciles, then into 100 book-to-market sub-deciles.


  • Controlling for size, there is no relationship between beta and average return
  • Size is significant in predicting average returns
  • Book-to-market equity is also significant in predicting average returns, and has an even bigger effect than size
  • The effects of leverage and E/P are captured by size and book-to-market equity

Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers

Jensen, Michael C., 1986, “Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers,” The American Economic Review 76 (2), 323-329.

Purpose:  This paper develops a theory linking debt, agency costs of free cash flow, and corporate takeovers.

Theory:  Managers seek to maximize their own influence, and not necessarily shareholder return.  They also have discretion over free cash flow, which represents an agency problem for firms with high free cash flows and low growth prospects.  Debt can be used to limit managers’ discretion over cash flows, and so increases in leverage can create value for shareholders beyond the tax implications.

  • Debt holders can force firm reorganization without bankruptcy more quickly and easily than equity holders.  This means higher-leveraged firms tend to be leaner and better managed.
  • Takeover targets should include firms with poor earnings and poor management, or firms with excellent earnings that management does not use to create value.
  • Lack of growth opportunities frequently leads to the undertaking of value-destroying projects.  Firms pursuing diversification and firms in industries with overcapacity often fit in this category.
  • These firms ought to see more takeovers, threats of takeovers, and subsequent debt increases.

Empirical Evidence:

  • Evidence from LBOs and going-private transactions
    • Most firms that are taken private are those with low growth and high potential for free cash flows—hence, high agency costs.  Strip financing (all bond-holders hold equal proportions of debt in each tier of seniority) reduces conflict of interest among bond holders, which gives them more power over the firm.
    • Very few of these transactions have gone into bankruptcy, suggesting that debt holders can force management efficiency and limit suboptimal investments.
  • Evidence from the oil industry
    • During the 1970s, oil prices increased and optimal capacity decreased, so that oil firms were both highly profitable and destined to shrink.  Oil managers continued investing in exploration & discovery projects that returned less than the cost of capital.
    • Around this time, oil companies began to merge and restructure under threat of takeover.  They increased leverage and cut value-destroying investments.


  • Managers of firms with low growth opportunities can’t be trusted with high cash flow.
    • Leverage can be used to limit the free cash flow agency problem.
  • Firms with high cash flows and low growth opportunities should be prime takeover targets.
  • Acquisitions financed with debt and cash should create more value than similar transactions done with equity.