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

Corporate
Finance

Ultimate
Objective

Maximize
FV
Capital
Structure
Theories

MM
Theory

Agency
Theory

M. Jenson
& H.
Meckling
Theory of
Firm

Informati
on
Asymmet
ry Theory

Dividend
Decisions

Behaviou
r Finance

Market
Timing
Theory

Regulatory Financial
Market
Cash Management
Relationship between
strategic decisions and
financial decisions

1. Introduction
Theory of Firm : An empty box?
"Theory of firm" is not a theory of firm
but actually a theory of markets in
which firms are important actors. The
firm is a "black box" operated so as
to meet the relevant marginal
conditions with respect to inputs and
outputs and maximising profit

Property rights
They are the human rights
possessed by participants. Agency
theory helps explain behavior
implications of these rights between
owner-manager and bondholders or
stakeholders.
contract between the owner and the
manager of the firm

Agency costs
Agency relationship is a contract under the
principal engage the agent to perform service
on their benefits which involves some
decision making authority to the agent.
Agency costs include:
1. The monitoring expenditures by the principal
2. The bonding expenditure by the agent
3. The residual loss

Definition of the Firm

The private corporation or firm is
simply one form of legal fiction which
serves as a nexus for contracting
relationships
legal fiction: certain organizations to
be
treated as individuals

2. Agency Costs of Outside

D: optimal set between non- Equity
pecuniary

and firm value

B: the final set when the fraction of

outside equity is(1-)
V: V* V0 V
F: F* F0 F
V: value of the firm
V
1
F: managers expenditures on nonpecuniary benefit
U: indifference curve of the manager
VF: budget constraint
: fraction of managers equity

Theorem
For a claim on the firm of (1-) the
outsider will pay only (1-)V when he
expect the firm to have given the
induced change in the behavior of
the owner- manager
W = S0 + Si = S0 + V(F, )
= S0 +V = (1-)V + V
= V

The role of monitoring activities in

reducing agency cost
M : the optimal monitoring expenditure of
the outside equity holders (Distance
between C & D)

Potential buyers will be indifferent between the

following two contracts:

1. Purchase of a share of (1-) of the firm at a total

price of (1- )V and no rights to monitor or control
the managers consumption of perquisites

2. Purchase of a share of (1-) of the firm at a total

price of (1- )V and the right to expend resources
up to an amount they pay, M which will limit the
owner-managers consumption of perquisites to F

Irrelevance of capital
structure
MM theorem is based on the assumption that probability distribution of
cash flows of the firm is independent of capital structure

But bankruptcy cost and tax benefits will invalidate this because
probability distribution of cash flows change with probability of
bankruptcy theory defines optimal capital structure

But theory lacks to detail why debt was used prior to existence of current
tax subsidies? Use of other debt securities having no tax advantage?

No theory to determine what determines fraction of equity claims held by

insiders as opposed to outsiders

3. Agency Cost on Debt

Three part of agency cost on debt
1. The incentive effects associated
with highly leveraged firms
2. The monitoring and the bonding
expenditures by the bondholders
and the owner-manager
3. Bankruptcy and reorganization costs

Incentive Effects
With ease of debt financing owner-manager will have strong
incentive (or inclination towards) to engage in activities or
investments which promise very high payoffs if successful
even if they have a very low probability of success. If they turn
out well, he captures the gain otherwise creditors bear most of
the losses.
If owner-manager has the opportunity to first issue debt then
among two different investments, he can take debt on less
riskier project and can further transfer wealth to himself or
other equity shareholders.
The opportunity wealth loss is caused by the impact of the
debt on the investment decision of the firm.

The role of monitoring and bonding

cost
Monitoring costs- There are provisions
or controls imposed to
managements decision by debtholders. Cost involved in these
provisions are monitoring cost.
Owner-manager will try to minimize
these costs by bearing bonding costs
(at comparatively low prices)

4. Theory of corporate ownership

structure
Optimal ratio of outside equity and debt
Si : inside equity
S0 : outside equity
B : debt
S = S0 + Si ; V = S + B
E = S0 / ( B + S 0 )
As0(E) : agency cost of outside equity
AB(E) : agency cost of debt
AT(E) : As0(E) + AB(E)

Because owner-manager bear agency

costs, from his standpoint optimal
proportion of outside funds to be
obtained from equity (Vs debt) is that
E which results in minimum total
agency costs.

Risk and the demand for outside

financing
The owner-manager will invest 100%
of his personal wealth in the firm and
then resort to outside financing but
in fact he allocate his wealth in
diversified ways to reduced the risk.
So when he want to reduce this cost
he will bear some agency cost (from
the issuance of equity and debt)

5. Qualifications and extensions of

the analysis
Multiperiod and extension of the
analysis
Throughout the analysis only single
time investment decisions have been
taken into consideration and have
ignored the future financinginvestment decisions. If taken into
account it will have some changes
such as the future sales of outside
equity and debt, managers decision,

 The control problem and outside

owners agency costs
It has been assumed that all outside
equity is nonvoting. If they have
voting right, the manager will
concern about the effects on his
long-run welfare of losing effective
control of the firm (the danger of
being fired). So to determine an
equilibrium distribution of outside
equity is necessary.