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

Presented by Julie Ao, Fall 2016

2
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.

 William H. Meckling: He was the dean emeritus of the Simon

Business School, University of Rochester. He passed away in 1998.

 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.
3 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.

 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.

 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.
4
Theory of the Firm
 Not a theory of the firm, but a theory of markets in which firms are
important actors.

 We have no theory that explains how the conflicting objectives of

the individual participants are brought into equilibrium so as to yield
this result

 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 black box view of the firm have been cited by
Adam Smith and Alfred Marshall, among others.
5
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.

 Specification of rights is generally achieved through contracting,

individual behavior in organizations, including the behavior of
managers.

 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.
6 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.

 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.

 Agency costs are the sum of:

 The monitoring expenditures by the principal,
 The bonding expenditures by the agent,
 The residual loss
7  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.

 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).
8 Definition of the Firm
 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’

 Alchian and Demsetz (1972): Emphasis on role of ‘contracts as a

vehicle of voluntary exchange’

 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.
9 Agency Costs of Equity---Overview
 If a wholly owned firm is managed by the owner, he will make
operating decisions which maximize his utility.

 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.

A Simple
Formal
Analysis
10 Agency Costs of Equity Suppose the owner sells a
share of the firm, 1-α, and
 Simple Formal Analysis retains for himself a share, α

D A: If the owner-manager is
When the owner has 100% free to choose the level of
If the manager
of the equity could choose perquisites, his welfare will be
whatever level maximized by increasing his
of non- consumption of non-pecuniary
pecuniary
Value of
benefits he liked benefits
the firm

A B: If the owner has decided

to sell a claim 1-α of the firm,
Tradeoff the
owner- his welfare will be maximized
manager faces
between non- Theorem: For a claim on the
pecuniary
benefits and his firm of (1-α) the outsider will
wealth after the pay only (1-α) times the value
sale he expects the firm to have
given the induced change in
the behavior of the owner-
manager
11 Agency Costs of Equity
 Determination of Optimal Scale of the Firm Hence, the manager
stops increasing the
size of the firm when
the gross increment in
Idealized solution: manager obtained
value is just offset by
outside financing with zero costs the incremental loss
When When outside involved in the
investment is
100%
equity financing is
used to help
consumption of
financed by finance the additional fringe
entrepreneur investment and
the entrepreneur benefits due to his
owns a fraction of declining fractional
the firm
interest in the firm
Gross
agency The manager’s
costs complete
opportunity set for
combinations of
wealth and non-
pecuniary benefits
given the existence
of the costs of the
agency relationship
with the outside
equity holders
12 Agency Costs of Equity
 The Role of Monitoring and Bonding Activities in Reducing Agency Costs

If the equity market is competitive

and makes unbiased estimates of the
effects of the monitoring
expenditures on F and V, potential
buyers will be indifferent between the
following two contracts:

Optimal (1) Purchase of a share (1-α) of the

monitoring
expenditure on
firm at a total price of (1-α)V’ and
the part of the no rights to monitor or control the
outsiders managers consumption of
perquisites
(2) Purchase of a share (1-α) of the
firm at a total price of (1-α)V’ and
the right to expend resources up
to an amount equal to D-C which
will limit the owner-manager’s
consumption of perquisites to F
13 Agency Costs of Equity
 Optimal Scale of the Firm in the Presence of Monitoring and Bonding Activities

The existence and

size of the agency
costs depends on
the nature of the
monitoring costs, the
Optimum point tastes of managers
for non-pecuniary
benefits and the
supply of potential
managers who are
capable of
financing the entire
venture out of their
personal wealth
14 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:
1) 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
2) The monitoring costs these incentive effects engender
 Manager is likely to incur bonding costs to reduce effects of internal and
external monitoring costs
3) Bankruptcy costs
 Operating costs and revenues of a firm are adversely affected
15
 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.

 In summary, the agency costs associated with debt consist of:

1) The opportunity wealth loss caused by the impact of debt on the
investment decisions of the firm
2) The monitoring and bonding expenditures by the bondholders
and the owner-manager (the firm)
3) The bankruptcy and reorganization costs
16 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.
17 Theory of the Corporate Ownership Structure
Total agency costs
associated with the Total agency costs
“exploitation” of the associated with the
outside equity presence of debt in
holders by the the ownership structure
Total owner-manager
agency
cost
(1) As long as capital markets are
efficient the prices of assets such
as debt and outside equity will
reflect unbiased estimates of
the monitoring costs and
redistributions which the agency
relationship will engender
(2) The selling owner-manager will
bear these agency costs

Thus, from the owner-manager’s

standpoint the optimal proportion
of outside funds to be obtained
from equity (versus debt) for a given
level of internal equity is that E
which results in minimum total
agency costs.
18 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.

 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.

 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.
19 Extension of Analysis
 The application to the very large modern corporation whose managers
own little or no equity

 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.

 Theory of the supply of warrants, convertible bonds and convertible

preferred stock
20 Conclusions
 “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”.

 “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