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Evaluating Agency Theorys Strengths and Weaknesses

Paper Type: Free Essay Subject: Finance
Wordcount: 2985 words Published: 1st Jan 2015

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Agency theory refers to contract whereby principal engage with agent to perform some act on their behalf. The act involved giving power to agent for some decision making. Everyone work on the feet of benefit that can be gained for oneself. That’s why it is strongly agreeable that agent, as a utility maximizer will not act at the best interest of principal. Therefore, agents may cheat if they were not monitored by principal and principal, on the other hand, must bear agency cost to avoid suffering loss. These agency costs includes monitoring costs of agent, bonding costs whereby agent will try to show that they are not self-serving, and residual losses that are too costly to monitor.

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In general, agency cost is one of a type of internal cost incurred from, or must be paid to, an agent acting on behalf of a principal. Agency costs mainly originated from the separation of control, divergence of ownership and control and the different objectives (rather than shareholder maximization) of the managers. For example, difference of interest between shareholders and management. Shareholders hope that management could operate the company in a manner that increases shareholder value. But management may wish to run the company in ways that can maximize their personal authority and well-being that may not be in favor of the shareholders.

From the paper, Jensen and Meckling’s (1976), they used zero agency-cost firms whereby the manager is the firm sole shareholder as a reference point of comparison for all other cases of ownership and management structures. At one utmost of ownership and management structures are firms whose managers possess 100 percent of the firm. These firms, by their definition, have no agency costs. At the other utmost are firms whose managers are employees with no equity in the firm. In between are firms where the managers possess some, but not all, of their firm’s equity. They stated that agency costs are higher among firms that are not 100 percent owned by their managers and these costs increase as the equity share of the owner-manager declines. In other words, agency costs increases with a reduction in managerial ownership.

In situation (where the managers own some, but not all, of their firm’s equity) whereby monitoring cost were included by equity holder to alter the opportunity the owner-manager has for possessing non-monetary benefits can decrease the owner-manager’s consumption of perquisites. Examples of monitoring cost include auditing and budget restrictions. However, owner-managers will still willingly enter into the contract as it will increase the firm’s value. The particular increase in the value of the firm that accrues will be reflected in the owner’s wealth, but his welfare will be increased by less than this because he forgoes some non-monetary benefits he previously enjoyed.

In situation (where the managers own some, but not all, of their firm’s equity) whereby owner-manager expands resources to guarantee to equity holder that he would limit his activities, bonding cost incurred. Examples of bonding cost include contractual limitation on manager’s decision making power and auditing of financial account by public accountant. If the bonding costs were all under owner-manager’s control, he will gain the benefit as such of monitoring costs gives.

In a nutshell, the manager finds it in his interest to incur these costs as long as the net increments in his wealth which they generate (by reducing the agency costs and therefore increasing the value of the firm) are more valuable than the perquisites given up. Although by incurring the monitoring and bonding cost increases the efficiency of firm, it does not maximize the firm’s value. This is because, the cost of separation of ownership and control occurred as a result of differences between efficient solution of zero monitoring and bonding cost and value of firm when there is positive monitoring cost. And Jensen and Meckling’s (1976) showed that agency cost will be positive as long as monitoring costs are positive. Size and existence of agency cost depends greatly on the nature of monitoring costs, the needs of managers for non-monetary benefits and supply of potential managers who are able to finance the firm with personal wealth.

Agency cost of debt indicates that there will be a rise in cost of debt when there is difference in the point of views of bondholders and management. There are a few fractions of agency costs of debts. The first one is the incentive effects related with debts. An owner-manager will intend to involve in investments with high risk and high profits with the financial structure of debt-typed claims because the loss will bear by debt-holder. For example where there are two investment options, A and B. The option B will help owner-manager to gain more equity, while the option A will give back more profit to bondholder. The choice of investment will only been done after the bonds are sold. Bondholders buy bonds from the company and suppose the company to invest in option A. However, due to the incentive effect, the manager did not invest as they expected but invest in option B which will help them gain more in equity. This will cause welfare loss to the bondholders. However, this decision could be realized by bondholders. If the bondholders knew the choice of the manager, they will only willing to buy the bonds at a lower price. Due to this action, the overall firm value may decrease. This reduction of firm value will be the residual loss which is also known as agency cost. This amount of agency cost is liable to owner-manager.

Monitoring and bonding costs are another fraction of agency costs. In order to preserve the benefits of their own, bondholder will restrict the management’s decisions. They will set contracts in details to monitor the owner-manager’s behavior. The contracts may influence the capacity of the management to make the best decision and decrease the profit of the firm. The decrease of the profit, the cost of enforcing the contracts and all the other costs related with the contracts are the monitoring costs. As the monitoring costs are borne by owner-manager, he will hope to minimize the monitoring cost, and therefore he will incur bonding costs. The bonding costs are incurred to give assurance to the bondholder that he will not turn aside from his promised behavior. He will only voluntarily bond himself in contract when such deed benefits him.

Bankruptcy and reorganization costs are also one of the components of the agency costs of debts. Bankruptcy occurs when the firm unable to pay debt obligation. The cost of bankruptcy is always the interest of the potential buyers of fixed claims. This is because this cost will decrease their payoffs if the bankruptcy happens. If the probability of the bankruptcy cost is high, the willingness of the price buyer to pay for fixed claims will be low. The value lost because of the cost of bankruptcy will be the agency costs. The probability of bankruptcy will negatively affect the operating costs and the incomes of the firm. A firm may need to pay higher salaries in order to keep engaged the employees in the firm when the probability of the firm gone high. Besides, the firms that provide after sales services will also face decrease of sales volume.

There are some factors that encourage the firms to use corporate debts although the factors discussed above will discourage them. Tax subsidy on interest payments is one of the factors. There are some theories verified that the use of risky debt will increase the value of the firm because of the tax subsidy on the interest payments. The firm will enjoy the benefits if in the end the benefit of tax subsidy covered the agency costs that incurred from debt. Furthermore, the firm will also be motivated to use corporate debt when there is a profitable investment while the firm has insufficient fund to invest. The firm will incur them provided that the profits generated from investment are greater than the marginal agency costs of debts.

There is some critical variables to be concerned besides the amount of debt and equity for a given size firm, such as inside equity (Si) held by the manager, ouside equity (So) and debt (B) held by anyone ouside of the firm. Therefore, the term of ownership structure is applied rather than capital structure. Besides that, we have to identify that the cost to be inccured is related to the use of debt or outside equity in a firm.

A firm which is facing capital limitation can finance the full capital value of its present and future projects if there are other individuals in the economy who have large enough amount of personal capital to finance the firm. Besides that, a firm can prevent property lossess related to the agency costs due to the sale of debt or outside equity. If not, the firm needs to acquire the excess capital in the debt market with the absence of such individuals. As a result, the owner-manager is the individual who bears the agency costs since the project is unprofitable enough to cover existing costs included agency costs. So, it is important for owner-manager who bears these costs to reduce the agency costs in order to increase his property.

If the capital markets, such as the value of assets where the debt and outside equity is eficient enough to indicate the agency costs estimation with unbiased, these agency costs will bear by the selling owner-manager. So, the task of owner-manager who will take the risk to bear the cost of agency is to determine the perfect ratio of ouside equity to debt, So/B. Therefore, from the owner-manager’s point of view, the optimal ratio of outside funds to be acquire from equity to debt for a given level of internal equity is that E which results in minimum total agency costs, E*= So* /(B €«€ So )

The total market value of the equity is S = Si+So,

The total market value of the firm is V = S+B.


E*= (So/ B + So)

At(E= ASo(E) + AB(E)




Figure 1

We assume that the size of the firm is remain constant and the actual value of the firm V, will rely on the agency costs incurred. Figure 1 indicate the agency costs is divided into two separate components, ASo(E) represents the total agency costs of outside equity holders by the owner-manager and AB(E) represents the total agency costs of debt incurred in the ownership structure. A´(E) = ASo(E) + AB(E) is the total agency cost.

The optimal proportion of outside financing shown as E* where total agency costs is minimum, AT(E*). When Eº€ So/(B+So) is zero, there is no outside equity, the manager’s intention to use the outside equity is zero. As E increases, his incentives to exploit the outside equity is increase and hence the agency costs ASo(E) increase. When the outside equity So = E = 0, there are a maximum of outside funds are acquire from debt.

As the amount of debt decreases to zero, these costs, AB(E) decrease because his intention to rearrange wealth from the bondholders to himself falls. It is because the total amount of debt reduce, and therefore it is more easier to rearrange any amount given to the debtholders. Besides that, his reallocation shares which is accomplished is falling since So is rising and therefore inside equity, Si/(So+Si), his share of the total equity is falling.

At(E* Ko)


At(E* K1)


AB(E K0)

ASo(E K0)

AB(E K1)

AS0(E K1) K1)

High outside financing

Low outside financing

Figure 2. Agency cost functions and optimal ouside equity as a fraction of total outside financing, E*(K), for two different levels of outside financing.

In order to identify the consequences of rising the amount of outside financing, and therefore decrease the amount of equity held by the manager,Si, the value of the firm, V* remain constant. The net consequence of the greater used of outside financing given the cost functions in figure 2 is to increase the total agency costs from A´(E*;Ko) to A´(E*;K1), and to increase the optimal portion of outside funds acquired from the sale of outside equity. Therefore, the larger the firm may incurred higher total agency costs due to the monitoring function is internally more difficult and expensive in a larger organization.

At(K V*1)

At(k V*o)

At(E K V*)

Total agency costs


Fraction of firm financed by outside claims

KFig. 3. Total agency costs as a function of the fraction of the firm financed by outside claims for two firm sizes, V*1>V*o.

Of course, there are certain risks when the owner-manager demanded for outside financing. If the owner-manager is alway relies on outside funding, he will have his entire treasure invested in the firm. Therefore, he would not optional to outside funding until he had invested 100 percent of his personal wealth in the firm.

Since, the manager who invests all of his wealth in a firm, he will bear a welfare loss. However, he can prevent the agency costs when he increasing relies on outside funding by taking certain actions. If the returns from assets are not totally correlated with the project, an individual can decrease the riskiness of the returns on his part by dividing his treasure into different assets by diversifying. Of course, he will be contributed to become a minority stockholder in order to avoid this risk by suffer a wealth loss as he reduces his proportion ownership because prospective shareholders and bondholders will take into account the agency costs.

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The analysis of this paper is only related with a single investment-financing decision and has excluded the issues of incentives which influencing future financing-investment decisions. However, some changes have been made to conclude that the costs and benefits will be changed by the expectation of future sales of outside equity and debt which may benefit to the manager himself. If he brings out a high probability of chance for dealing business, he probably can gain a big amount of future capital from outside sources and it will help to increase the business benefit and reduce the size of the agency costs. But, finite life of individual cannot eliminate the agency cost because it needs to consider more on his successors who think of own benefit and interest.

Normally, they assumed that all outside equity are no right to vote. The manager will suffer the decreasing of his partial ownership in the long-run welfare and limit his action to control over the corporation and even fire the manager if they have right to vote. Besides, if the costs of decreasing the dispersion of ownership are lesser than the benefits to be acquired from decreasing the agency costs, it will pay some individual to purchase the shares in the market to decrease the dispersion of ownership.

Moreover, they proposed an alternative way for the owner-manager who carried both equity and debt outstanding to get rid of the agency costs of debt. It will be no incentive if he is bound contractually to have a portion of the total debt equal to his partial ownership of the total equity. If the manager is getting balance between the debt and equity holders, the net effect will be zero. But, the limitation is they have not conduct to the large corporation and just perform in the small company which cause them couldn’t have a clear picture on formal contract of reducing agency cost.

“Theory of Monitoring” is a major part of the analysis which they expected monitoring activities help to develop particular characteristics to those institutions and individuals will be given a lot of advantages through these activities. The analysis demonstrates that the degree of security analysis activities will lower the agency costs related with the division of ownership and control, and they are socially productive absolutely. Furthermore, they supported that there are a lot of advantages of the security analysis activity to be played in the bigger capital value of the ownership claims to firms which is not in the day to day portfolio returns if this analysis is correct. If the firm can make the private returns to analysis same with the private costs of such activity, the security analysis will be balanced. However, the analysis will not reveal the social product of this activity which will include high level output and capital value of ownership claims. Therefore, the argument suggests that, it will be overwhelming when the shareholders pay straightforwardly to have the perfect monitoring conducted if there is imperfect of security analysis being conducted.

The problems discovered in the study included Pareto inefficient which is the obtainable set of financial claims on outcomes in a market fails to extent the fundamental step. An inadequacy conclusion is generally come out without clear attention to the costs of discovering latest claims or costs of maintaining the expanded set of markets which refer to the welfare improvement. But, the problem is the difficulty of formulation a positive analysis of the maximum level of individual behaviors in the economy that may influence them to generate and sell contingent claims. So, self-interested maximizing behavior of individuals becomes the first step in the way of implementing a study of the supply of markets issue. They suppose that planning the question of the perfect markets in terms of the combine both the demand and supply conditions will be very productive instead of implicitly assuming that latest claims from independent human effort.


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