Journal Article Analysis: Theory of the firm: Managerial behavior, agency costs and ownership structure. In Corporate governance 

Jensen, M. C., & Meckling, W. H. (2019). Theory of the firm: Managerial behavior, agency costs and ownership structure. In Corporate governance (pp. 77-132). Gower.

Michael Jensen and William Meckling’s study has been mentioned more than 3900 times in journals since 1976 on diverse topics like finances, accounting, econometrics, management, business, psychology, economics, and decision sciences. The article aims at elaborating on how agency costs can affect the ownership structure and managerial behavior of the firm. Also, the article present issues in connection with the progress in the sector of financial aspects, property rights and financial aspects to develop a theory to guide the organizational ownership framework. Whereas the agency theory has developed over the last years, I don’t think the concepts have been diffused well in the wider business areas. The study concentrates on the association between stockholders and upper-level management which are the categories that correspond when the owner is the manager. More so, the authors emphasize on the concept of business corporations that are publicly held in a beautiful social invention founded on the common goal of developing wealth by means of investment vehicles sustained by firms.

In the beginning, the authors mention “the firm is not individual” to highlight on the aspect of network of relationships in the firm as a contractual relationship that collaborates individuals having diverse wants and objectives with the common end goal of something productive. Property rights forms the basis of their theory of the firm. The specifications and nature of such contracts shape the individual behavior within the institution and therefore it is crucial not to lose focus on this when we humanize organizations as singular simplicity entities.

“Contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, etc. The problem of agency costs and monitoring exists for all of these contracts… There is in a very real sense only a multitude of complex relationships (i.e., contracts) between the legal fiction (the firm) and the owners of labor, material, and capital inputs and the consumers of output”.

The article is applied widely by firm stakeholders and researchers to understand the effects of agency relationships. Despite its popularity, some researchers over time have improved on the study and the theory of firm ownership structure and agency issues. The agency relationship aspect and the corporate ownership structure has discussed vividly on the separation and control concept. Nonetheless, various studies are founded on the theory of the firm developed by Jensen and Meckling (1976); some of them giving empirical evidence of the theoretic aspect whereas others focus on the application of the idea in different settings while others address the limitations of the research. The research by Jensen and Meckling (1976) is applied widely by other researchers and stakeholders of different firms to understand the consequences of agency relationships. Also, its popularity has been used by other researchers to improve on the subject and the theory of agency issues and the ownership structure of the firm. The aspect of separation and control in this research has been analyzed in-depth in agency relationships and corporate ownership. As a result, various articles are founded on this research, some of the studies give empirical evidence of the theoretic notions while others focus on addressing the limitations of the study.

 Agency Issues

Theory of the firm regarded the firm an “empty black box” and the firm were viewed as behavior maximizing and profit maximizing. Jensen and Mackling article is based on the aspect of behavior maximizing. Actually, the property rights determines the incentives and costs of the firm managers. The study considers the agency costs as the cost differences between the firm owners and the high management. According to the study, the agency cost combines the monitoring cost, bonding cost and residual cost.

Agency costs = monitoring costs + bonding costs + residual loss

 In his later research, Jensen considered the agency cost as the structuring cost, contracts cost, costs of moral hazards and information cost (Jensen & Smith, 2000) hence forming a significant contribution to the corporate structure and value. Issues in the agency can happen when the agents do not behave in the principal’s best interest. For various organizations, “the separation of ownership and control” between the management (agent) and shareholders (principals) is case-in-point. As it occurs in the event managers make decisions that are self-centered and which do not align with the interests of the shareholders. The issue of the agency is a more general one. However, the research of Jensen and Meckling concentrates on the relationship between ownership structures and agency costs whereas the issue exists at various levels of cooperation and organization. It is also not a modern problem as postulated by Adam Smith in his research in 1776.

“The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or Iess, in the management of the affairs of such a company.”

Adam Smith, The Wealth of Nations, 1776.

Both monitoring and bonding costs on one side decrease the divergence of interests and on the other side enhance the value of the firm. The costs related to debts, that is, bankruptcy and reorganization form the principal reason why debt is not only regarded as the only source of outside funds (Rashid, 2016). A point will be reached when the costs will be more compared to the costs because of outside equity. The theory by Jensen Meckling of high agency costs with decrease of inside equity proportion is enhanced comprehensively by Crutchley et al., where he suggests that finding the optimal level of debt-equity ratio causes reduced leverage costs and agency costs. It is significant for more researchers to discuss this crucial topic to expand on the available studies.

Agency costs of equity

The research article describes the agency costs related to debt and equity.

Agency costs of outside equity: Jensen and Meckling concentrate on the possibility of change in behavior if the owners of the firm decides to sell their company stakes to the outside buyers. There are two considerations that are worth to be looked into. Firstly, it is expected that managers that own the company to make decisions entirely that will in turn maximize on their utility. Then, the utility encompasses non-monetary and monetary benefits and it may entail the reputation, challenge, admiration and experience which are associated with the job. According to Jensen and Meckling, these agency costs occur only when the owner-managers decides to sell their company shares. This is because they can get the same non-monetary value from their role at a personal risk and cost fraction. Moreover, the owner-managers may decide not to track optimal projects as a result of differences in their personal risks, benefits and efforts. Others may pursue excessive risk provided the limited downside whereas some may decide to play safe granted the reputational risk and personal effort. Even though the owners can decide to take actions such as replacement and monitoring among others that will in turn warrant enhanced alignment interests. Outright agency costs eradication in a real setting is usually cost-prohibitive a similar concept to evolutionary biology parasite-load.

Monitoring costs and preferences: According to Jensen and Meckling (1776), there are various factors that can impact the agency cost of equity and they include the attitudes and preferences of the managers, how manageable is for managers to pursue their personal interests over the interests of the principals and the bonding and monitoring costs. For instance, design, implementation and enforcement of suitable performance appraisals, company policies and compensation packages to enhance principal-agent alignment which does not occur freely.

Replacement risk: It is vital to concentrate on the labor market. If relative supply of potential managers reduces it reduces the agency costs. For instance, if managers experience a lower replacement risk, they may develop increased confidence to take actions in their own self-interest. On the other hand, if they are constantly in replacement fear, the managers may make decisions that rank self-preservation over the long term interest of the company.

Bankruptcy risk, limited liability and capital irrelevance: The study portrays that the limited liability characteristic of equity assertions are only enticing to the owners that are outside in spite of the agency costs onset. Also, bankruptcy risks and the yearning to maintain borrowing power may inhibit debt financing demand. However, Jensen and Meckling asserts that such theories are inadequate and the agency costs related to equity and debt are useful in explaining the ownership and capital structure observed.

The assumption of the research restricts its adoption in the corporate sector setting. For instance, it is not possible in the real world to lack trade credit and taxes. In addition, there exists other conventions that could provide solution to the agency issue if the writers adopted them, for example, doing away with convertible financial instruments like convertible bonds and warrants. If the organization allows convertible instruments, there will be reduction of agency costs since the shareholders will know the convertible bondholders rights. Rules P.6 and T.4, that is, the existence of uncertainty and idiosyncratic risks have been disregarded forming part of the limitation in adopting the research in the corporate sector. In the actual world, the cost and benefit analysis entails the related risks of investments but in the study, the risks related to the firm value and the prospect investment projects are disregarded and hence the assumption restricts the generalization of this notion of research. Moreover, the research shows that the organizational value relies on the wealth possessed by the owner and the taste, that is if the owner gets less non-monetary benefits, the firm value will be higher and the vice versa. Also, the risk is related with the selection of the project, the owners of the firm in most cases will pursue projects of high risks when they are many. According to Ross and Jerold (1983), opportunistic behavior will consequently reduce the value of the firm.

The research suggests that the stockholders do not possess the voting rights, and it is anticipated here that this particular assumption limits the power of the stockholder to change the company policies so that there would exist deviation of interests that would in turn cause rising in agency costs (Haugen & Senbet, 1988). It is possible to argue that the debt holder has the capability of interfering with the policies in the company through indenture yet the stockholders do not own the voting power though they are more liable for the financial claims of the organization. Through relaxing this notion and by employing empirical analysis, the relationship of the agency cost and the rights of outside fund providers could be enhanced.

Agency costs of debt

Debt financing is enticing in various ways like tax subsidies experienced on interest payments and financing when one cannot access equity capital. However, the research by Jensen and Meckling (1976) highlights three agency problem aspects which discourages the idea: incentive effects, bankruptcy costs and monitoring costs. In the beginning, there is a prospect for irrational behaviors, that is, when the debts are unsustainable, the management might decide to pursue high risk projects and having high rewards in profile so that it becomes beneficial to everyone when all goes well but the creditors experience lose when everything goes sour (Jensen & Meckling, 1776). Then, whereas debtholders have the capability of introducing covenants, monitoring and provisions to hinder the irrational incentive effects, such costs are not usually cheap. Lastly, the authors postulates that the bankruptcy costs and reorganization exhibit a dampening impact on dept uptake.

According to Modigliani and Miller (1958), their research shows that when taxes and bankruptcy costs exist, the capital structure in turn will be relevant on the potential cash flow of the organization and in finding the value of the firm, such costs will be vital. In most cases, the valuation of the firm depends not only on its capital structure but also on the costs related to the components of the capital structure. When the outsiders are engaged, either the debt holders or the equity holders, there is a reduction in the firm’s value because of agency costs related to them. The difference in the firm’s value because of these costs is residual loss. However, the lose can be decreased by defining the ratio of inside equity and outside equity. Optimal capital structure is the ratio of inside and outside funds that stabilizes the cost related to the benefits and agency issues because of yield differentials and tax exposure (Singh & Davidson III, 2003). Selecting the most suitable equity ratio can enhance organizational value by decreasing costs and giving suitable funds for investments in projects with high returns.

Ownership structure

The agency costs of equity and debt can shift the firm towards a certain type of ownership structure. The research study postulates that if capital markets are competent, then the debt price and price of outside equity should include these agency costs, that is, if the debt agency cost increases, the outside equity should become more enticing. From the perception of the owner-manager, the optimal debt mix to the outside equity should cause minimum total agency costs for a particular manager equity (Ang, Cole & Lin, 2000). Jensen and Meckling use an ownership structure instead of a capital structure to highlight the attention about stake of the manager in the firm.  

Diversification: The study also shows that aversion to risk and the selection of optimal portfolio can assist in explaining the diversification of the owner-manager. This means that managers who averse the risks by concentrating their entire wealth in one company will exhibit general welfare loss and hence these managers are willing to surrender something to avoid the risk. Therefore, the diversification cost according to the authors is portrayed in agency costs that bondholders and shareholders introduce into pricing.

Scaling: The research also suggests that the agency costs are proportional to the size of the firm, that is, the bigger the firm translates to more expensive and challenging resources to monitor it and effectively enforce behaviors.

Control: It is vital to acknowledge that outside equity possesses voting rights and in a sense, it is a market for ownership and control. Therefore, outsiders can pursue this pathway when the cost-benefit trade-off of reducing agency issues favors them (Ang, Cole & Lin, 2000). The history of business is dominated by circumstances of conflicts for control which entails proxy fights, outright market purchases, and tender offers.

Multiperiod: In real-world setting, any financial and business decision made by owner-managers will shape the future set of financing on the table. As a result, the owner-managers who regard their relationships and reputation with shareholders and debtholders may tend to act in their own interests.

The authors of the research did not take into consideration the lending policies of large financial corporations such as banks, corporations with outside investments and diverse organizational forms, supply and demand of finances in the market, issuing debt costs, and outside equity when elaborating on the ownership structure of the firm. As a result, this limits the application of the research study. Fama and Jensen (1983) explored the suitable techniques to handle the agency issues in different firms and its effect on residual claims on the authority of decisions involving asset allocation.

In conclusion, several practitioners and researchers have adopted extensively on the theory of the firm. In addition, the theory has been improved by some authors as well as addressing the research gaps and more research on the subject is still needed to address the present research gaps. Changes in policies of corporate firms, data access, and market diversity can help the researchers to discuss more on agency relationship and firm ownership structure hence applying the theory in various diverse situations.

References

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360,

Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. Readings in economic sociology, 6-17.

Axelrod, R., & Hamilton, W. D. (1984). The evolution of cooperation. science, 211(4489), 1390-1396.

Jensen, M. C., & Smith, C. W. (2000). Stockholder, manager, and creditor interests: Applications of agency theory. Theory of the Firm, 1(1).

Rashid, A. (2016). Managerial ownership and agency cost: Evidence from Bangladesh. Journal of business ethics, 137, 609-621.

Haugen, R. A., & Senbet, L. W. (1988). Bankruptcy and agency costs: Their significance to the theory of optimal capital structure. Journal of Financial and Quantitative Analysis, 23(1), 27-38.

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American economic review, 48(3), 261-297.

Fama, E. F., & Jensen, M. C. (1983). Separation of ownership and control. The journal of law and Economics, 26(2), 301-325.

Ang, J. S., Cole, R. A., & Lin, J. W. (2000). Agency costs and ownership structure. the Journal of Finance, 55(1), 81-106.

Singh, M., & Davidson III, W. N. (2003). Agency costs, ownership structure and corporate governance mechanisms. Journal of banking & finance, 27(5), 793-816.