Agency Theory (Finance)

When human interaction is viewed through the lens of the economist, it is presupposed that all individuals act in accordance with their self-interest. Moreover, individuals are assumed to be cognizant of the self-interest motivations of others and can form unbiased expectations about how these motivations will guide their behavior. Conflicts of interest naturally arise. These conflicts are apparent when two individuals form an agency relationship, i.e. one individual (principal) engages another individual (agent) to perform some service on his/her behalf. A fundamental feature of this contract is the delegation of some decision-making authority to the agent. Agency theory is an economic framework employed to analyze these contracting relationships. Jensen and Meckling (1976) present the first unified treatment of agency theory.

Unless incentives are provided to do otherwise or unless they are constrained in some other manner, agents will take actions that are in their self-interest. These actions are not necessarily consistent with the principal’s interests. Accordingly, a principal will expend resources in two ways to limit the agent’s diverging behavior: (1) structure the contract so as to give the agent appropriate incentives to take actions that are consistent with the principal’s interests and (2) monitor the agent’s behavior over the contract’s life. Conversely, agents may also find it optimal to expend resources to guarantee they will not take actions detrimental to the principal’s interests (i.e. bonding costs). These expenditures by principal and/or agent may be pecuniary/non-pecuniary and are the costs of the agency relationship.

Given costly contracting, it is infeasible to structure a contract so that the interests of both the principal and agent are perfectly aligned. Both parties incur monitoring costs and bonding costs up to the point where the marginal benefits equal the marginal costs. Even so, there will be some divergence between the agent’s actions and the principal’s interests. The reduction in the principal’s welfare arising from this divergence is an additional cost of an agency relationship (i.e. ”residual loss”). Therefore, Jensen and Meckling (1976) define agency costs as the sum of: (1) the principal’s monitoring expenditures; (2) the agent’s bonding expenditures; and (3) the residual loss.

Barnea et al. (1985) divide agency theory into two parts according to the type of contractual relationship examined – the economic theory of agency and the financial theory of agency. The economic theory of agency examines the relationship between a single principal who provides capital and an agent (manager) whose efforts are required to produce some good or service. The principal receives a claim on the firm’s end-of-period value. Agents are compensated for their efforts by a dollar wage, a claim on the end-of-period firm value, or some combination of the two.

Two significant agency problems arise from this relationship. First, agents will not put forward their best efforts unless provided the proper incentives to do so (i.e. the incentive problem). Second, both the principal and agent share in the end-of-period firm value and since this value is unknown at the time the contract is negotiated, there is a risk sharing between the two parties (i.e. the risk-sharing problem). For example, a contract that provides a constant dollar compensation for the agent (principal) implies that all the risk is borne by the principal (agent).

Contracts that simultaneously solve the incentive problem and the risk-sharing problem are referred to as “first-best.” First-best contracts provide agents with incentives to expend an optimal amount of effort while producing an optimal distribution of risk between principal and agent. A vast literature examines these issues (see e.g. Ross, 1973; Shavell, 1979; Holmstrom, 1979).

The financial theory of agency examines contractual relationships that arise in financial markets. Three classic agency problems are examined in the finance literature: (1) partial ownership of the firm by an owner-manager; (2) debt financing with limited liability; and (3) information asymmetry. A corporation is considered to be a nexus for a set of contracting relationships (Jensen and Meckling, 1976). Not surprisingly, conflicts arise among the various contracting parties (manager, shareholder, bondholders, etc.).

When the firm manager does not own 100 percent of the equity, conflicts may develop between managers and shareholders. Managers make decisions that maximize their own utility. Consequently, a partial owner-manager’s decisions may differ from those of a manager who owns 100 percent of the equity. For example, Jensen (1986) argues that there are agency costs associated with free cash flow. Free cash flow is discretionary cash available to managers in excess of funds required to invest in all positive net present value projects. If there are funds remaining after investing in all positive net present value projects, managers have incentives to misuse free cash flow by investing in projects that will increase their own utility at the expense of shareholders (see Mann and Sicherman, 1991).

Conflicts also arise between stockholders and bondholders when debt financing is combined with limited liability. For example, using an analogy between a call option and equity in a levered firm (Black and Scholes, 1973; Galai and Masulis, 1976), one can argue that increasing the variance of the return on the firm’s assets will increase equity value (due to the call option feature) and reduce debt value (by increasing the default probability). Simply put, high variance capital investment projects increase shareholder wealth through expropriation from the bondholders. Obviously, bondholders are cognizant of these incentives and place restrictions on shareholder behavior (e.g. debt covenants).

The asymmetric information problem manifests itself when a firm’s management seeks to finance an investment project by selling securities (Myers and Majluf, 1984). Managers may possess some private information about the firm’s investment project that cannot be credibly conveyed (without cost) to the market due to a moral hazard problem. A firm’s securities will command a lower price than if all participants possessed the same information. The information asymmetry can be resolved in principle with various signaling mechanisms. Ross (1977) demonstrates how a manager compensated by a known incentive schedule can use the firm’s financial structure to convey private information to the market.

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