Agency Costs and Capital Structure Review

Ang S. James et al. (2000) used two alternative measures of agency costs. First they take direct agency costs, calculated as the difference in dollar expenses between a firm with a certain ownership and management structure and the no agency cost base case firm. This measure captures excessive expenses including perk consumption. They standardized expenses by annual sales.

The agency costs of debt have been widely discussed, but Jensen M. Michael (1986) argue that the benefits of debt in motivating managers and their organizations to be efficient have been ignored. Agency theory has also brought the roles of managerial decision rights and various external and internal monitoring and bonding mechanisms to the forefront of theoretical discussions and empirical research. Great strides have been made in demonstrating empirically the role of agency costs in financial decisions such as to explain the choices of capital structure, maturity structure, dividend policy, and executive compensation ( Ang S. James et al, 2000).

Managers with substantial free cash flow can increase dividends or repurchase stock and thereby pay out current cash that would otherwise be invested in low return projects or wasted. This leaves managers with control over the use of future free cash flow, but they can promise to pay out future cash flows by announcing a permanent increase in the dividend. Such promises are weak because dividends can be reduced in the future because of various reasons. The fact that capital markets punish dividends cuts with large stock price reductions is consistent with the agency costs of free cash flow.

Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus debt can be an effective substitute for dividends. By issuing debt in exchange for stock, managers are binding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increase.  In doing so, they give shareholders recipients of the debt the right to take the firm into bankruptcy court if they do not uphold their promise to make the interest and principal payments. Thus debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. These are potential determinant of capital structure Jensen M. Michael (1986).

Jensen M. Michael (1986) identifies two types of conflicts. Conflicts between shareholders and manages happen because managers hold less than 100% of residual claim. Consequently, they do not retain the entire gain from their profit improvement activities, but they do bear the entire cost of these activities. For example, managers can invest less effort in managing firm resources and may be able to transfer firm resources to their own, personal benefit, e.g. by consuming perquisites such as corporate jets, plush offices, building empires etc. the managers bears the entire cost of refraining from these activities but captures only a fraction of the gain. As a result managers indulge in these pursuits relative to the level that would maximize firm value. This inefficiency may be reduced; the larger is the fraction of the firms’ equity owned by the manager.

Holding constant the manager’s absolute investment in the firm, increase in the fraction of the firm financed by debt increases the manager’s share of the equity and mitigate the loss from the conflict between the managers and shareholders. Conflicts between debt holders and equity holders arise because the debt contract gives equity holders an incentive to invest sub optimally.

More specifically the debt contract provides that if investment yields large returns, well above the face value of the debt, equity holders capture most of the gain. If however the investment fails, because of limited liability, debt holders bear the consequences. As a result, equity holders may benefit from going for broke i.e. investing in very risky projects, even if they are value decreasing. Such investments result in a decrease in the value of the debt. The loss in value of the equity from the poor investment can be more than offset by the gain in equity value captured at the expense of debt holders. Equity holders bear this cost to debt holders, however, when the debt is issued if the debt holders correctly anticipate equity holders’ future behavior. In this case, the equity holders receive less for the debt than they otherwise would.

Thus the cost of the incentive to invest in value decreasing projects created by debt is borne by the equity holder who issues the debt. This effect, generally called the asset substitution effect is an agency cost of debt. Jensen M. Michael (1986) further argued that an optimal capital structure can be obtained by trading off the agency cost of debt against the benefit of debt as previously described.

Their second measure of agency cost is a proxy for the loss in revenues attributable to inefficient asset utilization, which can be taken as consequence of poor investment decisions or from management’s shirking. They calculated agency costs as the ratio of annual sales to total assets, an efficiency ratio. The result of Ang S. James et al. (2000) is direct confirmation of the predictions made by Jensen and Meckling (1976). Agency cost is higher among firms that are not 100 percent owned by their mangers, and these costs increase as the equity share of the owner manager declines. Hence, agency costs increase with a reduction in managerial ownership, as predicted by Jensen and Meckling (1976).

Harris and Raviv (1991) referred to various researcher that their model predict that leverage is positively associated with firm value (Hirshleifer and Thakor (1989), Harris and Raviv (1990a), Stulz (1990). Also, leverage is expected to be negatively associated with the extent of growth opportunities (Jensen and Meckling, 1976) and ( Stulz, 1990).