FIN 562 Topics in Corporate Finance

Prof. Dan Rogers

Week 1 Discussion
Agency theory & its applications
The following discussion is based on Stockholder, Manager, and Creditor Interests:
Applications of Agency Theory, by Michael Jensen and Cliff Smith. This article
briefly discusses agency theory as it relates to the corporate form of organization in the
United States. In particular, it provides a summary of the sorts of conflicts of interest that
exist between the major contracting parties in corporations (shareholders, management,
and creditors). The article also highlights various mechanisms for reducing costs
associated with agency conflicts.
Agency theory provides a framework for describing the structure of the corporate form
of organization. Jensen and Meckling (1976) view the corporation as a nexus of
contracts among individuals. The corporation itself does not have preferences and does
not make choices as to courses of action. Rather, individuals within the contracting
framework of the organization seek to structure contracts that allow for maximization of
their own utility functions. To the degree that agents have conflicting objectives, the form
of contracts between agents reflects the equilibrium of a complex contractual system.
Definition: An agency relationship is a contract in which one or more persons (the
principal) engage another person(s) (the agent) to take actions on behalf of the principal
which involves the delegation of some decision-making authority to the agent.
Definition: Agency costs are defined by Jensen and Meckling (1976) as the sum of the
monitoring and bonding costs plus any residual loss that occurs because of the necessity
of the contractual relationship.
Monitoring and bonding costs reflect those costs necessary to enforce the
contract. It pays to expend resources on enforcement only to the point where
the reduction in the loss from noncompliance equals the increase in
enforcement costs.
Residual loss represents the opportunity loss remaining when contracts are
optimally but imperfectly enforced. Agency costs reflect imperfect markets
(recall that the fundamental premises of corporate finance start with perfect
markets).
The parties to a contract bear the agency costs of the relationship. So,
maximizing agents will seek to minimize agency costs. This idea implies that
agents possess incentives to write contracts that allow for enforcement costs
(i.e., monitoring and bonding) to the point where the marginal cost equals the
marginal benefit to the contracts ability to reduce the residual loss.
Shareholder-Manager Agency Conflict
The standard structure of the publicly held corporation commonly observed in the United
States creates a separation of ownership from control. In other words, management

controls the operating decision-making authority of the corporations business while the
stockholders (who own the residual claim on the cash flows produced by the corporation)
become outside observers. This situation forms much of the basis for principal-agent
theories. These theories create models of optimal compensation contracts between the
principal (outside stockholder) and agent (manager) in various settings. The key aspect of
these types of models is that any variable compensation can only be contingent on
observable outcomes (profits or stock returns are examples that come to mind). If the
manager cannot exercise complete control over the observable outcome, then a firstbest contract cannot be designed. In other words, the corporations expected cash flows
(after paying the managers compensation) will always be less than if the manager were
the 100% owner of the corporation.
So, why do public corporations exist?
A principal answer to the question is related to the benefits of diversification. Given
individual risk aversion, required rates of return are lower for diversified shareholders
(relative to those of undiversified shareholders). Thus, managers of firms possess
incentives to be diversified in their own shareholdings. This becomes especially true for
more complex business types.
Agency costs of outside equity
Because the management of a corporation does not bear the costs associated with its
decisions (as reflected by changes in the market value of the corporation), managers have
incentives to pursue utility-maximizing actions that might not increase firm value. The
classic example is the ownership and executive usage of corporate jets (if this topic is
interesting to you, check out Yermack (2006)). Is corporate-owned aircraft used in
shareholders best interests? If not, the value lost as a result of the suboptimal usage (in
the extreme case, corporate aircraft ownership might be a negative NPV project) reflects
an agency cost associated with the separation between ownership and control.
So, how can agency costs of outside equity be controlled?
Controlling the shareholder-manager conflict
While there may be a multitude of mechanisms to control the inherent agency problem
associated with the separation of ownership from control, most are dictated by the
corporations board of directors. Management compensation plans are administered
by the board, and in almost all cases, there is a separate compensation committee whose
job it is to oversee management compensation. The choice of how much compensation as
well as the form of compensation are important issues faced by the board. The structure
and amount of compensation will provide differing incentives for the corporations
managers, and outside shareholders want compensation to reinforce the principle of value
creation. Improper compensation structure can lead to continued agency conflicts. For
example, excessive salary as a proportion of total compensation could result in:
Asset substitution (less risky investments than is optimal)
Overretention of funds within business
Not enough leverage

In each of these cases, managements incentives are to take actions that reduce risk below
the optimal level.
Outside the boards realm, there is a larger market for corporate control. We can think
of this generally as the fact that corporations can change ownership, and new owners can
replace management. If current management is taking actions that depress the market
value of the corporation, then theoretically, another owner can buy the firm, replace
management with a more competent team, and unlock value. In practice, this is much
harder to do.
Bondholder-Stockholder Agency Conflict
Black (1976) states, there is no easier way for a company to escape the burden of a debt
than to pay out all of its assets in the form of a dividend, and leave the creditors holding
an empty shell.
The comment above epitomizes the agency conflict between shareholders and lenders.
While this statement represents an extreme idea regarding shareholders incentives,
potential creditors are cautious because of this possibility. In particular, some corporate
decisions increase shareholder wealth while simultaneous reducing the value of creditors
claims. Smith and Warner (1979) identify the following four major conflicts:
Payout to shareholders
Claim dilution
Asset substitution (risky investment)
Underinvestment
Because providers of capital are not stupid (or at least should not be!), they will anticipate
these types of incentives and structure loan contracts accordingly (in terms of price and
covenants).