You are on page 1of 20

Theory of the Firm : Managerial

Behavior, Agency Costs and Ownership

Michael C. Jensen and William H.
Journal of Financial Economics 3 (1976)
305 - 360






M. Jenson
& H.
Theory of

ry Theory


r Finance


 Regulatory Financial
 Cash Management
 Relationship between
strategic decisions and
financial decisions

Introduction Theory of Firm : An empty box? "Theory of firm" is not a theory of firm but actually a theory of markets in which firms are important actors.1. The firm is a "black box" operated so as to meet the relevant marginal conditions with respect to inputs and outputs and maximising profit .

contract between the owner and the manager of the firm .Property rights • They are the human rights possessed by participants. Agency theory helps explain behavior implications of these rights between owner-manager and bondholders or stakeholders.

The bonding expenditure by the agent 3. The residual loss .Agency costs Agency relationship is a contract under the principal engage the agent to perform service on their benefits which involves some decision making authority to the agent. The monitoring expenditures by the principal 2. Agency costs include: 1.

Definition of the Firm • The private corporation or firm is simply one form of legal fiction which serves as a nexus for contracting relationships • legal fiction: certain organizations to be treated as individuals .

2.Equity pecuniary and firm value B: the final set when the fraction of outside equity is(1-) V: V*  V0  V’ F: F*  F0  F’ V: value of the firm V 1 F: manager’s expenditures on nonpecuniary benefit U: indifference curve of the manager VF: budget constraint : fraction of manager’s equity . Agency Costs of Outside D: optimal set between non.

Theorem For a claim on the firm of (1-) the outsider will pay only (1-)V when he expect the firm to have given the induced change in the behavior of the owner.manager W = S0 + Si = S0 + V(F. ) = S0 +V’ = (1-)V’ + V’ = V’ .

The role of monitoring activities in reducing agency cost M : the optimal monitoring expenditure of the outside equity holders (Distance between C & D) .

Potential buyers will be indifferent between the following two contracts: 1.α)V’ and no rights to monitor or control the manager’s consumption of perquisites 2. M which will limit the owner-manager’s consumption of perquisites to F . Purchase of a share of (1-α) of the firm at a total price of (1.α)V’’ and the right to expend resources up to an amount they pay. Purchase of a share of (1-α) of the firm at a total price of (1.

Irrelevance of capital structure MM theorem is based on the assumption that probability distribution of cash flows of the firm is independent of capital structure But bankruptcy cost and tax benefits will invalidate this because probability distribution of cash flows change with probability of bankruptcy – theory defines optimal capital structure But theory lacks to detail why debt was used prior to existence of current tax subsidies? Use of other debt securities having no tax advantage? No theory to determine what determines fraction of equity claims held by insiders as opposed to outsiders .

Bankruptcy and reorganization costs .3. The monitoring and the bonding expenditures by the bondholders and the owner-manager 3. The incentive effects associated with highly leveraged firms 2. Agency Cost on Debt • Three part of agency cost on debt 1.

. • If owner-manager has the opportunity to first issue debt then among two different investments. • The opportunity wealth loss is caused by the impact of the debt on the investment decision of the firm. he can take debt on less riskier project and can further transfer wealth to himself or other equity shareholders. he captures the gain otherwise creditors bear most of the losses.Incentive Effects • With ease of debt financing owner-manager will have strong incentive (or inclination towards) to engage in activities or investments which promise very high payoffs if successful even if they have a very low probability of success. If they turn out well.

There are provisions or controls imposed to management’s decision by debtholders. Owner-manager will try to minimize these costs by bearing bonding costs (at comparatively low prices) . Cost involved in these provisions are monitoring cost.The role of monitoring and bonding cost Monitoring costs.

V = S + B E = S0 / ( B + S 0 ) As0(E) : agency cost of outside equity AB(E) : agency cost of debt AT(E) : As0(E) + AB(E) . Theory of corporate ownership structure • Optimal ratio of outside equity and debt Si : inside equity S0 : outside equity B : debt S = S0 + Si .4.

Because owner-manager bear agency costs. . from his standpoint – optimal proportion of outside funds to be obtained from equity (Vs debt) is that E which results in minimum total agency costs.


Risk and the demand for outside financing The owner-manager will invest 100% of his personal wealth in the firm and then resort to outside financing but in fact he allocate his wealth in diversified ways to reduced the risk. So when he want to reduce this cost he will bear some agency cost (from the issuance of equity and debt) .

.5. If taken into account it will have some changes such as the future sales of outside equity and debt. Qualifications and extensions of the analysis • Multiperiod and extension of the analysis • Throughout the analysis only single time investment decisions have been taken into consideration and have ignored the future financinginvestment decisions. manager’s decision.

• The control problem and outside owner’s agency costs • It has been assumed that all outside equity is nonvoting. . the manager will concern about the effects on his long-run welfare of losing effective control of the firm (the danger of being fired). So to determine an equilibrium distribution of outside equity is necessary. If they have voting right.