Agency theory: its importance and agency costs of outside debt

Introduction

This essay begins with an introduction to agency theory and agency costs as compiled from various literature sources. The author then delves into why agency costs exist and explains the components of agency costs by analysing a sole-proprietorship firm that brings in outside equity-holders and/or debt financing. The analysis of the agency costs is done under the assumptions and restrictions of the paper by Jensen and Meckling (1976). An explanation of the components of the agency cost is followed by its importance in determining the ownership structure of the firm. The author also touches on the importance of agency costs based on the widespread influence of agency theory in the field of corporate governance. Finally, the agency costs of outside equity as defined by Jensen and Meckling (1976) are measured by proxies mentioned in McKnight and Weir (2009) and their efficiency is assessed with references to the literature.

Agency Theory and Types of Agency Costs

Agency theory is concerned with the consequences of conflicts of interest within a business organisation. When a company’s ownership structure changes from a sole proprietorship to one involving more than one owner (of the equity) there will be a conflict of interest between the equity owners and the management of the firm. Due to this divergence in their interests, decisions made by the management may not lead to wealth maximization for all the parties.[1] Agency costs are the costs incurred by the principal (equity owners) because of the existence of the agent (management). Agency theory analyses agency costs by judging financial decisions in terms of risk, profitability and the trade off between the interests of the parties.[2]

Agency costs in a business can arise due to conflicts of interest between the management and equity owners, known as Type I agency problems, or conflicts between majority shareholders holding a large block of shares and the minority shareholders, known as Type II agency problems.[3] Another type of agency problem is found between the interests of the shareholders and the company’s stakeholders (such as customers, employees, suppliers, etc.). Irrespective of the two parties between whom the conflict arises, agency costs occur because each party in a relationship is keen to maximize their utility. In this case, value maximization becomes a zero sum game where one party has to be worse off for the other to be better off.

The principal bears certain costs to reduce the possibility of the agent prioritizing his/her value over the value of the principal. For the equity holders, these costs are classified as monitoring costs (undertaken by the principal), bonding costs (undertaken by the agent) and residual costs (the reduction in the value of the firm due to the presence of a principal-agent relationship).[4] In the case of debt-funding in the organization, agency costs can be divided into monitoring costs (undertaken by the bondholder), residual costs (change in the value of the firm due to the manager’s incentive to transfer value from bondholders to equity-holders, of whom he/she is one), the opportunity cost of the wealth (to the bondholder) and bankruptcy costs (the increase in the probability of the firm going bankrupt due to a high amount of leverage).[5]

Agency Costs of Debt and Outside Equity

According to the paper by Jensen and Meckling, (1976) agency costs begin to creep into the organization when sole proprietors sell a portion of their equity to another individual but retain all the management. When such a person is the only individual, his/her utility as a manager and an owner coincides and there is no principal-agent relationship or agency cost involved. However, when he\she sells even a small portion of equity but retains all the management functions, agency costs creep in because while he\she retains all the benefits of spending on perquisites, he\she forgoes a proportion of the value created for the firm (as it is passed onto the other equity holder). Now, there is a divergence in his\her utility as a manager and an owner and so, as a rational utility maximization, the owner-manager will spend more on perquisites than he\she did earlier as the sole-proprietor. This increase in the expenditure on perquisites will lead to lower cash flows being available to the organization to spend on positive NPV projects, thereby leading to a reduction in the value of the firm. This cost makes up the residual loss portion of agency cost.

A key assumption of this paper is that the external equity holder is a rational, non-voting shareholder. This assumption has important implications for the agency costs incurred. As the external equity holder is a rational investor, he/she will expect the owner-manager to increase expenditure on perquisites as his/her share of equity reduces. Therefore, it is reasonable to assume that he/she will factor this into the price he/she pays for the portion of equity purchased. However, he/she will also need to monitor the activities of the owner-manager to ensure that the value of the firm does not fall below expectations because then he/she stands to lose money. Therefore, he/she will undertake monitoring activities to restrict the freedom of the owner-manager in spending excessively on perquisites. These costs are known as the monitoring costs of agency cost.

As mentioned earlier, the outside equity holder is a rational investor who expected the value of the firm to fall and therefore paid less for his/her share of the equity. This implies that the entire effect of value reduction is borne by the owner-manager. Therefore, it is also in the best interests of the owner-manager to not spend heavily on perquisites and to make the outside equity holder feel secure about his/her investments. If he/she doesn’t do so, he/she might be unable to get additional funding when he/she needs to invest in profitable projects. This leads to the owner-manager willingly undertaking budget controls, internal auditing and reporting financial statements, etc. to ensure that the rights of the outside equity holder are protected and aligned more closely with those of the owner-manager. These costs make up the bonding costs portion of agency costs.

Agency costs are also incurred when the owner-manager uses debt finance in the business. Even without the benefit of a tax shield, debt finance is used because of its leveraging benefits. Therefore, as discussed earlier, the owner-manager still bears all the value reduction of the firm due to the principal-agent relationship but his/her wealth maximization is higher due to the ability to invest in highly profitable ventures without having to share more than a fixed portion of the wealth being created. As the bondholder will also be a rational investor, monitoring costs will be incurred that will be factored into the value of the debt and the interest payments required. The bondholder will issue covenants to restrict the behavior of the management. Because the owner-manager would like to be able to get funds from the markets in the future, he/she will continue to incur bonding costs.

The crucial difference in the agency costs due to outside equity and debt is the agency cost due to the risk of bankruptcy. Bankruptcy costs are the main reason why most firms are not funded with a very small equity base and high levels of debt. The bondholders factor bankruptcy costs into the cost during the issue of debt. It is the probability of the company being unable to meet its payments and is of concern to the bondholder. The price that buyers of bonds agree to pay will be inversely related to bankruptcy costs.

Importance of Agency Costs

Agency costs help explain why debt is used as a source of financing even without the benefit of a tax shield. Modigliani and Miller (1963) state that, in a world without tax benefits, the composition of the firm is irrelevant. However, Jensen and Meckling (1976) maintain that the optimal ownership structure of a firm is dependent on the trade-off between agency costs of debt and equity. This helps us explain why even without tax benefits, debt is a popular source of finance. Furthermore, it would not be incorrect to say that agency theory is the crux of the development of the stream of corporate governance. If it were unimportant or negligible, governments would not spend time creating governance codes to protect the interests of shareholders and bondholders. It also helps us explain how even when management is highly efficient, it is possible to not create maximum value.

Analysis of the proxies used by McKnight and Weir (2009)

As stated above, agency costs have an impact on the ownership structure of the firm. McKnight and Weir (2009) analyse the effect of changing ownership variables to look at the impact on the agency costs being incurred. They use sales-to-assets turnover to evaluate whether the management is efficiently maximizing shareholder wealth. They suggest that high sales imply an effective use of company resources, which in turn leads to shareholder wealth maximization and to reduced agency costs.[6] A similar study has been carried out in the US[7] and even though there are drawbacks, like revenue being generated perhaps not being distributed to the shareholders, it is a useful measure of agency costs as it looks at the efficiency of management and its policies.

The second measure of agency costs in their research looks at the free cash flows and growth opportunities available to the firm. This is in line with the literature by Jensen and Meckling (1976); they state that when a manager has excessive cash flows available but not enough growth opportunities, the implication is that the excessive cash would be used on perquisites and that the management is not investing enough in future growth opportunities. Even if the management pays higher dividends in the present, it is compromising on the future prospects of the company. It also hints at a weakening of the external forces of regulation, as the company no longer needs to go to the financial market to get capital for its projects. This gives the management greater flexibility in choosing how to utilize the funds.[8]

Finally, McKnight and Weir (2009) look at the acquisition activities of the firm. They argue that a large pool of money available to the managers might be used for maximizing the utility of management by encouraging takeovers of other firms. A huge body of research[9][10] proves a lack of positive returns to the shareholders of the acquiring firm and, therefore, high merger activity can be a signal of high agency costs as it leads to the reduction of the shareholder value, thereby implying a residual loss.

The proxies used by McKnight and Weir (2009) are the number of non-executive directors on the board. Non-executive directors discourage the discretionary use of resources by the management. Furthermore, in line with Jensen and Meckling (1976) they argue that a high percentage of owner-managers will lead to a lower agency cost because the entire agency cost is to be borne by the owner-manager and not by the outside equity holders. They measure this by using managerial ownership as a proxy. This is further backed by the research of Kim and Lu (2011) that an increase in CEO ownership of shares mitigates agency costs until the entrenchment effect comes into play[11]. McKnight and Weir (2009) also look at the effect of CEO tenure on the agency costs. The argument for this is that as the CEO becomes more entrenched in the organization, he can reduce the monitoring efficiency of the board of directors.[12]Weaker monitoring would lead to more managerial freedom and thereby lead to higher agency costs.

McKnight and Weir (2009) also argue that if a CEO works for the value maximization of his shareholders he/she will become sought after as a non-executive director on other boards. This proxy can be shown to be directly linked to the efficiency of bonding activities of the management, as stated by Jensen and Meckling (1976). A manager who works towards shareholder maximization will encourage bonding activities and reduce spending on perquisites. While this will not lead to lower bonding costs, it would lead to a lower residual loss and, it can be argued, the monitoring would be more effective with lower overall agency costs.

Finally, in line with Jensen and Meckling (1976), McKnight and Weir (2009) argue that higher debt financing of the firm would lead to lower agency costs. The rationale behind this is sound as it links back to the idea that if management is utilizing debt financing, then the bondholders would impose strong monitoring activities and debt covenants which would reduce the freedom of the management. The payment of interest and capital repayments also add a regular burden on the management, ensuring all funds available are used optimally to create value for the shareholders.

Conclusion

Agency costs are a key factor in every principal-agent relationship. They have numerous impacts on the field of finance which can be seen by the theory having led to the development of more stringent corporate governance laws and codes. McKnight and Weir have used suitable proxies to look at the multi-layered implications of an action on the agency costs.

Bibliography

Eisenhardt, K. M. (1989). Agency Theory: An Assessment and Review. The Academy of Management Review , 14, 57-74.

Fried, L. B. (2004). Pay Without Performance – the Unfulfilled Promise of Executive Compensation. Harvard University Press.

Belen Villalonga, R. A. (2006). How do family ownership, control and management affect firm value? Journal of Financial Economics , 385 – 417.

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: managerial behavior, agency costs and ownership structure. Journal of financial economics .

McKnight, P. a. (2009). Agency costs, corporate governance mechanisms and ownership structure in large UK publicly quoted companies: A panel data analysis. Quarterly Review of Economics and Finance , 139-158.

Ang, J. C. (2000). Agency costs and ownership structure. The Journal of Finance 55(1) , 81-106.

Jensen, M. C. (1993). The modern industrial revolution, exit, and the failure of internal control systems. Journal of Finance, 43 , 831-880.

Lu, E. H. (2011). CEO ownership, external governance, and risk-taking. Journal of Financial Economics 102 , 279-292.

Kelly, J. C. (1999). Unlocking shareholder value: The keys to success. New York: KPMG LLP.

Rau, R. &. (1998). Glamour, value and post-acquisition performance of acquiring firms. Journal of Financial Economics, 49 , 223-253.

Modigliani, F. a. (1963). Corporate Income Taxes and The Cost of Capital: A correction. American Economic Review 53 .

[1] (Fried, 2004)

[2] (Eisenhardt, 1989)

[3] (Belen Villalonga, 2006)

[4] (Jensen & Meckling, 1976)

[5] (Jensen & Meckling, 1976)

[6] (McKnight, 2009)

[7] (Ang, 2000)

[8] (Lu, 2011)

[9] (Kelly, 1999)

[10] (Rau, 1998)

[11] (Lu, 2011)

[12] (Jensen M. C., 1993)