Theory of the Firm- Managerial Behavior Agency Costs and Ownership Structure PDF

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Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure Michael C. Jensen and William H. Meckling Journal of Financial Economics 3 (1976) 305-360

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Presented by Julie Ao, Fall 2016

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Background Michael C. Jensen: He was LaClare Professor of Finance and Business Administration at the William E. Simon Graduate School of Business Administration, University of Rochester from 1984-1988. Now he is a professor at Harvard Business School, emeritus.

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William H. Meckling: He was the dean emeritus of the Simon Business School, University of Rochester. He passed away in 1998.

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The article has been cited over 3,900 times since 1996 in journals on topics as diverse as business, management, accounting, economics, econometrics, finance, decision sciences and psychology. Motivation and Objective Objective of the article is to “develop a theory of ownership structure for the firm” drawing on (1) property rights theory, (2) agency theory, and (3) finance theory.

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Jensen and Meckling (1976): (a) define the concept of agency costs, and show its relationship to the “separation and control” issue; (b) investigate the nature of the agency costs generated by the existence of debt and outside equity; and (c) demonstrate who bears these costs and why.

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Jensen and Meckling (1976) also provide a new definition of the firm, and show how their analysis of the factors influencing the creation and insurance of debt and equity claims.

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Theory of the Firm Not a theory of the firm, but a theory of markets in which firms are important actors.

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We have no theory that explains how the conflicting objectives of the individual participants are brought into equilibrium so as to yield this result

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The firm is a “black box” operated so as to meet the relevant marginal conditions with respect to inputs and outputs. The limitations of this

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black box view of the firm have been cited by Adam Smith and Alfred Marshall, among others. Property Rights What is important for the problems addressed here is that specification of individual rights determines how costs and rewards will be allocated among the participants in any organization.

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Specification of rights is generally achieved through contracting, individual behavior in organizations, including the behavior of managers.

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Jensen and Meckling (1976) focus on the behavioral implications of the property rights specified in the contracts between the owners and managers of the firm. Agency Costs Agency relationship: A contract under which one or more persons (principal) engage another person (agent) to perform some service on their behalf which involves delegating some decision making authority to the agent.

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If the contractual parties to the relationship are utility maximizers, there is good reason to believe that the agent will not always act in the best interests of the principal.

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Agency costs are the sum of:  The monitoring expenditures by the principal,  The bonding expenditures by the agent,  The residual loss Agency exists in all organizations and in all cooperative efforts, at every level of management in firms, in universities, in mutual companies, in cooperatives, in governmental authorities and bureaus, and in unions.

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Jensen and Meckling (1976) focus on the analysis of agency costs generated by the contractual arrangements between the owners and top management of the corporation. Jensen and Meckling (1976) assume that individuals solve the normative problems and given that only stocks and bonds can be issued as claims, they investigate the incentives faced by each of the contractual parties and the elements entering into the determination of the equilibrium contractual form characterizing the relationship between the manager (agent) of the firm and the outside equity and debt holders (principals). Definition of the Firm 

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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’

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

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Jensen and Meckling’s (1976) definition: Most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals. Agency Costs of Equity---Overview If a wholly owned firm is managed by the owner, he will make operating decisions which maximize his utility.

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The inclusion of outside equity will generate agency costs due to divergence of interests since the principal will then bear only a fraction of the costs of any non-pecuniary benefits he takes out in maximizing his own utility.

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Agency Costs of Equity Simple Formal Analysis

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Agency Costs of Equity Determination of Optimal Scale of the Firm

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Agency Costs of Equity The Role of Monitoring and Bonding Activities in Reducing Agency Costs

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Agency Costs of Equity Optimal Scale of the Firm in the Presence of Monitoring and Bonding Activities

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The Agency Costs of Debt Why don’t we observe large corporations individually owned with a tiny fraction of the capital supplied by the entrepreneur in return for 100% of the equity and the rest simply borrowed?  Reasons: • The incentive effects associated with highly leveraged firms  Strong incentive to engage in activities (investments) which promise very high payoffs if successful even if they have a very low probability of success.  Issuance of debt generates agency costs, which are the responsibility of the owner-manager • The monitoring costs these incentive effects engender  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 In general if the agency costs engendered by the existence of outside owners are positive it will pay the absentee owner (shareholders) to sell out to an owner-manager who can avoid these costs. •

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In summary, the agency costs associated with debt consist of: • The opportunity wealth loss caused by the impact of debt on the investment decisions of the firm • The monitoring and bonding expenditures by the bondholders and the owner-manager (the firm) • The bankruptcy and reorganization costs Theory of the Corporate Ownership Structure Jensen and Meckling (1976) use the term “ownership structure” rather than “capital structure” to highlight the fact that the crucial variables to be determined are not just the relative amounts of debt and equity but also the fraction of the equity held be the manager.

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Theory of the Corporate Ownership Structure Contributions A step in the direction of formulating an analysis of the supply of markets issue, which is founded in the self-interested maximizing behavior of individuals.

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The analysis of this paper would indicate that to the extent that security analysis activities reduce the agency costs associated with the separation of ownership and control they are indeed socially productive.

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In addition to the fairly well understood role of uncertainty in the determination of the quality of collateral there is at least one other element of great importance---the ability of the owner of the collateral to change the distribution of outcomes by shifting either the mean outcome or the variance of the outcomes. Extension of Analysis The application to the very large modern corporation whose managers own little or no equity

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The formulation of a positive analysis of the supply of markets  Since the demonstration of a possible welfare improvement from the expansion of the set of claims by the introduction of new basic contingent claims or options can be thought of as an analysis of the demand conditions for new markets.

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Theory of the supply of warrants, convertible bonds and convertible preferred stock Conclusions

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“They argue that agency costs (monitoring costs, economic bonding costs, residual loss) are an unavoidable result of the agency relationship. Although they argue that agency costs are nonzero, these costs are not regarded as non-optimal in their framework”.

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“If fact, they posit that because agency costs are borne entirely by the decision maker, the decision maker has the incentive to see that agency costs are minimized (because the decision maker captures the benefits from the reduction in agency costs)”. From Economic Foundations of Strategy...