ID 571-9580 Objective of the paper The paper integrates elements from the theory of agency, theory of property rights and theory of ownership structure of the firm defining agency cost showing its relationship with separation and control issue. Nature of the agency cost generate by existence of debt and outside equity
Who bear the cost of agency cost
Finding pecular and non pecular cost of agent Whats the idea? Agent = Manager Principal = stock and debt holders Agency problem applied to the firm. Monitoring expenses by principal Bonding expenditures by agent (such as insurance or financial statements). Residual loss (imperfect contracts) Firms are legal fictions which serve as a nexus for series of contracts. Agency Costs of Outside Equity 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. As a side note: Free rider problem and effect of outside block-holders. Agency Costs of Outside Equity VF when manager owns 100% no agency problem. Slope = -1 (waste a dollar $1 dollar loss). Owner sells (1-) of the firm. Buyer pays.? V1P1 buyer pays too much. V2P2 buyer pays right amount, assumes manager will be at F. Agency Costs of Outside Equity Optimal firm size OZBC when owner can afford project OZED when owner cannot afford and must finance w/equity. Agency Costs of Outside Equity Monitoring question Indifferent between no monitoring VBF and monitoring VCF (they say VCF) M= D-C of cost. Shareholders will have to monitor & Owner- manager reaps all benefits in price of claims Agency Costs of Outside Equity Monitoring and size of firm. Not much different Monitoring does not do much. This not even that important after considering free rider problem. Monopolies have same incentives Agency Costs of Outside Equity Limited liability as explanation for equity markets. Without it, lower cost of debt, but higher cost of information and monitoring for shareholders No articulate answer explains why firms raise so much money by selling equity. Agency Costs of Debt Risky borrowing can lead to success if project goes well if not would account for bankruptcy . Two mutually exclusive project 1 and 2 if 2 is riskier than 1 than owner would look for debt or borrowing rather than using his own money if he has to use his own money he would opt for project 1. Agency Costs of Debt Again, 2 investment opportunities, 2 > 1 Firm issues debt Stockholders have an option with exercise price = Bi (i=1 or 2) for the firm. Value of the option increases with volatility. Therefore, stock holders prefer to pursue project 2. So B2 < B1 . Bondholders will always assume firm will invest in project 2. They will pay B2 for any bonds the firm issues. Firms will thus have an incentive to invest in risky projects they want to fund with debt. Agency Costs of Debt Bond covenants can be attached to debt issues to prevent risky investments. It is costly to write and enforce them. 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 Agency Costs of Debt As leverage rises, so does probability of bankruptcy. Managers will have to be paid more. Contracts with suppliers will have to be shorter term. As leverage rises, option on firm goes more out of the money agency costs of debt rise. As equity rises, agency costs of equity rise. Optimal Leverage They recognize actual shape of upper curve is not known. E* minimizes agency costs. 2 levels of outside financing. In Comes Diversification Manager does not want all eggs in one basket Better to sell part of firm and invest in other assets. Demand for outside financing is really high with high managerial ownership. Conclusions Agency costs should affect capital structure. Agency costs exist between managers and shareholders, and between bondholders and shareholders. Agency costs of equity decrease with managerial ownership. Agency costs of debt increase as investment opportunities increase.