Critical Review

Theory of the firm: Managerial Behavior, Agency Costs and Ownership

Structure

Theory of firm: Managerial behavior, Agency Costs and Ownership Structure

(Jensen Meckling, 1976) is a comprehensive research study. It elaborates the

notion of agency cost, its association with the Separation and Control Issue,

explores the types of agency cost in the presence of debt and outside equity,

who are the payers of these costs and why, what is the optimal point of outside

financing at a given level of demand (Pareto optimality).

The topic of this research study is truly representing the contents of the study.

The amalgamation of three theories gave a new theory of ownership structure.

The abstract is explaining the title in a very concise manner. The objectives of

the study have been clearly explained in the abstract and the title shows the

new firm theory which is based upon the strands mentioned in the abstract.

Theory of
Finance
Agency Property
Theory Rights

Theory
of Firm

The ownership structure theory has been developed by using the previous

notions about the corporate structure, agency theory, property rights etc. This

new theory contributes to literature of corporate structure and agency issues, it

answered so many unsolved questions of the stakeholders of the firm regarding

the value maximization, financial structure of firms, leverage ratio of a firm and

its impact on the costs and value of a firm, restrictions and risks associated

with the firm and the significance of security analysis. Where the risks have

been ignored in the temporary assumptions of the study and the security

analysis showed no role in controlling agency cost i.e. rectified by the later

research studies.

This research study is widely used by the researchers and the stakeholders of

the firm in order to know about the consequences of agency relationship. Along

with, its popularity later researches improved this study and the concept of

agency issues and firm ownership structure. The concept of separation and

control given by this research study has been extensively discussed in the

corporate ownership structure and agency relationship literature. Various

research studies are based on the theory of firm given by the Jensen &

Meckling (1976), some of the researches provided the empirical evidence of its

theoretical notions, some are based upon application of its concepts in different

scenarios, and others addressed the limitations of this study. Jensen himself

participated in the improvement of this study in his later researches.

A customer value based theory of firm has been developed on the notion of

theory of firm given in this research paper (Stanley F.Slater, 1997). This theory

has been treated as the base of any new theory of firm whether it is customer

value theory of firm or trade-off theory of risk and benefits attached with the
firms (Jesen & Smith, 1985). The agency theory discussed in this article is also

used in the theoretical model of outsourcing strategy. Cheon et.al (1995)

argued that the agency cost theory helps in explaining the benefits associated

with the contract between firm and outsourcing entity, determinants of agency

cost have also been discussed. Firm is the nexus of many contracts between

individuals and it is the product of a complex equilibrium process, this notion

is widely reported in the later researches (Jesen & Smith, 1985).

Theory of the firm considered the firm an empty black box; firms were studied

in two ways as profit maximizing and as behavior maximizing. This study is

based upon the notion of behavior maximizing. The property rights are actually

the determinants of the cost and incentives of the managers of the firm. And

the agency cost has been reported in the paper as the cost of difference of

interests between high management and the owners of the firm. This research

study connotes the agency cost as the combination of monitoring cost, bonding

cost and residual loss. Jensen in his later research elaborated this agency cost

as the cost of contracts, structuring cost, information cost and moral hazard

cost (Jesen & Smith, 1985). This research study was a valuable contribution to

the literature of corporate value and structure. Most of the previous studies

depicted the structure of agency relation and the incentives associated with

this relationship in the absence of monitoring. This was the first study that

explored the form of agency cost and how and why it occurs and who will bear

it. The study also investigates the determinants of the equilibrium contractual
form of agency relationship. It was a prominent gap in the literature of

economics and social sciences.

Assumptions of this research study restrict its application to the corporate

sector scenarios. Like the absence of taxes and trade credit is not possible in

real world. Furthermore there are some assumptions that could be the solution

of agency problem if the author relaxed those assumptions i.e. no issuance of

convertible financial instruments e.g. warrants and convertible bonds etc. If

the firms allow to issue the convertible instruments the agency cost would be

reduces because the shareholders would be aware of the rights of convertible

bondholders (Jensen & Smith, 1985). Assumptions P.6 and T.4 i.e. the

presence of uncertainty and idiosyncratic risks has been ignored, these are

also the hindrance in the implications of the study on the corporate sector. In

real world the cost and benefit analysis includes the associated risks of the

investments but here in the paper the risks associated with the value of the

firm and the future investment projects are ignored. These assumptions limit

the generalization of this research notion. As in this study the value of the firm

depends on the tastes and wealth of the owner of firm, if the owner takes less

non-financial benefits the value of the firm will be high and vice versa. On the

other hand the risk is also associated with the project selection; owners usually

try to take the high risk projects when there are many owners of the firm. The

opportunistic behavior of parties reduces the firm value (Ross & Jerold, 1983).
It has been mentioned that the stockholders does not have voting rights, it is

proposed here that this assumption limits the stockholders power to change

the policies of the company so that there will be divergence of interests that will

result in the increase of agency costs. It could be argued here that the debt

holder could interfere in the policies of the firm via indenture but the

stockholders does not have any voting power, although they are more liable for

the financial claims of the firm. By relaxing this assumption and via empirical

investigation the agency cost relationship with the outside fund providers

rights could be improved.

The optimal scale of firm is the point where the cost associated with the decline

in the value of the firm due to non-pecuniary benefits of owner offsets the

increase in the value of firm due to new investment opportunity, beyond this

point owner stops enhancing the firm size. This is not the solution to avoid the

cost, it is proposed here that the owner may enhance the firm size but it is the

selection of investment opportunity that plays an essential role. The owner

must reduce the consumption of non-financial benefits and select the

profitable projects that could enhance the value of the firm.

Monitoring contracts increases the firms value because of the limited use of

owners non-pecuniary benefits. The difference in the value of firm without

outside equity and with outside equity in the presence of monitoring contracts

is the monitoring cost. Monitoring and bonding contracts have same increasing

influence on the value of the firm; these agency costs restrict the decline in the
value of the firm due to the involvement of outside equity. Ross & Jerold (1983)

provides the empirical evidence that the value of firm increases with the

bonding and monitoring activities e.g. auditing. It is suggested here that like

debt to equity proportion the corporate must specify the bonding costs and

monitoring cost proportion in order to predict the value of the firm more

accurately.

Elements of agency cost i.e. the taste of manager towards debt or outside

equity, decline in the value of firm, monitoring and bonding costs, competition

among managers, cost of measuring performance and the replacement cost of

managers has been clearly mentioned in the study. Depken et.al provides the

empirical evidence of the agency costs effects in the framework of this research

study, and the results are consistent with the theoretical notion i.e. the

reduction of agency cost with equity compensation and increase in agency

costs due to managerial ownership. It is suggested here that by using these

factors one could formalize a theory of avoiding or reducing these cost in an

efficient and value maximizing way. Further empirical analysis could give a

better understanding of the relationship between other factors and level of

agency costs. For example, empirical evidence showed that the bonding

contracts and agency costs have an inverse relationship (Depken et.al.). The

mix of these factors and their joint impact on the value of firm could be

explored further. Whether the value of firm reaches to optimal level by the

presence of these factors or not? Is there any trade-off effect among these costs

(e.g. by increasing the monitoring cost the cost of performance measurement

reduces)? Presence of agency cost has been strongly supported by the

arguments, agency cost is zero only in the absence of agency relationship and

when monitoring cost is zero. It increases with the increase in monitoring cost

irrespective of the existence of market competition.

Liability of outside fund sources does not make any difference either it is

limited liability in case of partnership or unlimited liability in case of corporate

form, both have the same liability cost after considering transaction costs. This

is the reason why liability is not the factor of agency cost and not included in

the determinants of capital structure.

Modigliani and Miller (1958) have been reported that in the presence of

bankruptcy cost and taxes, the capital structure would not remain irrelevant to

the future cash flows of the firm. In determining the value of firm these costs

plays an important role. The valuation of firm depends not only on the capital

structure but all the cost associated with capital structure components. With

the involvement of outsiders either equity holder or debt holder the value of the

firm reduces because of the agency cost associated with them, the difference in

the value of firm because of these costs is residual loss. This loss could be

reduced by specifying the proportion of inside and outside equity. Optimal

capital structure is that proportion of inside and outside funds that stabilizes

the cost associated with the agency issues and the benefits due to the tax

exposure and yield differentials (Amir et.al., 1981). The best selection of equity
ratio could increase the firm value by reducing costs and providing appropriate

funds for investment in profitable investment projects.

Both bonding and monitoring costs on one hand reduce the divergence of

interests and on the other hand increases the value of the firm. The reason

that why the debt is not the only source of outside funds is the costs

associated with it i.e. the bankruptcy costs and reorganization costs along with

agency cost. A point will come where these cost are more than the costs

associated with the outside equity. Jensen Mecklings notion of increased

agency issues with the reduction of inside equity proportion is also supported

by the Crutchley et.al., he connotes that the determination of optimal level of

debt to equity ratio leads to the reduction of agency costs and leverage cost. It

is very crucial topic to investigate about the proportion of debt to outside

equity. Whether this proportion remains same across firms in a single industry

or whether it changes across the industries is a future research topic.

Empirical analysis would be helpful to strengthen this notion. If the debt

proportion increased in the capital structure the chances of the liquidation and

bankruptcy increases, the best way out of this issue mentioned in the paper is

the merger, it is proposed here that if the condition of if and only if the value

of firm increases after merger could be mentioned, than it would have been a

better solution. A future research area is suggested here i.e. the impact of

factors encouraging the use of debt on its associated agency cost. Because the

debt enhances the value of the firm by investing in profitable investment

opportunities and the tax subsidies firm received, it may reduce the divergence

of interests between owner and bond holder.

The minimum point of total agency curve is also showing the optimal level of

outside equity in fig.5. The minimum point lies at the intersection of agency

cost curves associated with debt and outside equity. It gives the understanding

that there is inverse relationship between the two agency costs. It has been

mentioned in the paper that these relations of agency cost needs further

refinement. These curves has been drawn along with the costs of inside

ownership e.g. the cost of diversification and limited use of non-pecuniary

benefits by Crutchley et.al.(1999) and the relationships of these curves has

been further supported by other research studies. These agency costs and their

relationship with the proportion of outside equity could be investigated

empirically for further explanation. It has been reported in the study that as

the fraction of outside equity increases the agency cost increases at a

decreasing rate but the author did not take the managerial entrenchment in to

account, but Crutchley et.al., (1999) considered this factor in his research

study. Ang. J.S., Cole, R.A. and Lin, J.W (2000) investigates the absolute and

relative agency costs of associated with outside equity. Their study was based

on an explanation of the Jensen Meckling theory of firm, where the firm is

operated by a single owner and where there is no agency cost exists. They

check the agency cost under different management and ownership structures.
Similarly, the relationship between the debt to equity ratio and its associated

agency cost could be investigated. It has been reported in the literature that

the only reason why owner takes outside equity instead of investing his own

full investment is his desire to diversify across different asset classes in order

to attain higher returns and because of the uncertain returns of the investment

projects. Marginal utility of investors i.e. the outside fund providers has not

been taken in to account while discussing the ownership structure of the firm.

Marginal utility of investors plays an important role in deciding leverage ratio.

It could be studied in future.

As far as the time period of agency relationship is concerned, a future research

study could be designed to explore the impact of agency contract time period

on the cost associated with it. Whether the increased time period of agency

contracts with stakeholders reduces the agency cost or the agency cost

increases with the passage of time.

Control problems discussed in the section 6 of this study are only because of

the outside fund providers, if we reduce the outside equity the funds for

investment in profitable investment projects will also reduce. Robert & Lemma

(1981) reported that the firms should engage in buying and selling of stock

options in order to avoid the agency costs associated with outside fund

providers. He gave the solution of agency problems mentioned in the

framework of this study. In section 6.4 it has been mentioned that the security

analysis i.e. searching the undervalued and overvalued stocks in market is a

social loss. It is an ambiguous argument because it is only possible in the

efficient stock markets that the security prices truly represent all the public

and private information and it is an ideal case. In real world the security

analysis helps the brokers or investors to find such undervalued and

overvalued securities to generate profits by their subsequent buying and selling

(Khawaja &Mian, 2004). It is suggested here that the security analysis could

also help in controlling the agency cost, in case of undervalued securities the

outside equity holder will increase the monitoring cost in order to make the

stock prices accurate and in case of overvalued stock the owner-manager will

involve in the bonding activities to avoid the residual loss in near future.

Doukas et.al. (2000) has been reported that the security analysis is a

monitoring activity, he gave the empirical evidence that the security analysis

not only reduces the agency costs but it also has a positive relation with the

value of the firm.

Lending policies of the bank, large corporation with all outside investments and

different form of organizations, supply and demand of funds in the market,

cost of issuing debt and outside equity has not been taken in to account while

discussing the ownership structure of firm. Limitations of this research study

have been explored to some extent. Fama & Jensen (1983) have been explored

the appropriate techniques to address the agency issues in different forms of

organization and the impact of residual claims on the authority of asset

allocation decisions.
Theory of firm has been extensively used by the researchers and practitioners.

This theory has been improved by the latter researches as well as it gives many

research gaps to explore that are discussed in this critical review. Data access,

changing policies of the corporate firms and diversity of market could help the

researchers to further polish the view of agency relationship and firm

ownership structure in different situations.