When trade-off theory is refined further and corporate governance is taken into account, we are introduced to agency theory of capital structure. Jensen & Meckling (1978) were first to study the principal-agent problem and capital structure together. This theory specifically takes deeper look into financial stress costs that originates from the conflict between a company’s management and its creditors & shareowners. This leads to the optimal capital structure, when tax shield minus financial stress & agency costs are at the highest.
2.3.1. Principal-agent problem
Agency relationship is a contract between principal(s) and agent(s), where principal delegates responsibility and decision making authority to the agent. The problem stems from the presumption that the both, principal and agent, are utility maximizers.
Therefore, we can assume that some decisions can favor more the agent than the principal, which causes the agent to prefer and conduct those, if there were no restrictions. The problem is caused mostly from asymmetric information between these parties. Management has usually much more knowledge and inside information about the firm than owners and creditors as well as stakeholders cannot control and monitor everything that management does. Thus, principals should set incentives, which will prevent the management to deviate from their interests. (Jensen & Meckling 1978)
The problem is not always between managements and stakeholders, but as well it can emerge between principals. Sometimes stockholders and creditors can have different interests. Stockholders’ goal is that the company maximizes their welfare. This requires usually risk taking into some extent, as from risk comes the reward. However, a rational stockowner has a large and well diversified portfolio, which minimizes firm-specific risk.. On the contrary, risk is a major factor for bondholders. They usually want to
minimize it, since they benefit only from the interest, which has been predetermined in the contact. They do not have any chance to benefit from additional risk, which only worsens the probability of loan and interest payback. This can lead to two kinds of problems. First is asset substitution problem, which means that for first company takes cheap debt to invest in safe project, but then decides to invest to riskier asset. The second is underinvestment problem, which is a kind of opposite of the earlier. This problem arises, when a company invests too safely or little, improving the creditors’
position at the expense of the owners. Dividend problem appears, when owners want to share out most of the profits, which leads the firm to weaker solvency and weakens creditor’s position. In addition, there can be differences between creditors. Old creditors can suffer from new debt, as they are priced their interest and willingness to take risk by the factors that were present before the new debt. Especially new debt can harm old bondholders, if the terms of new debt are on the same level with the old debt. This is called claim dilution problem. (Jensen & Meckling 1978; Niskanen 2000; Smith &
Warner 1979)
2.3.2. Agency costs
Agency costs occur when managers do not maximize the value of a firm, and stakeholders’ monitoring and constraints cause costs. Morellec, Nikolov & Schürhoff (2012) predict that on average, the agency costs are 1.5% of total equity value, which would affect to leverage ratios. Maximizing value of a firm and finding all the most profitable projects can be tough and stressful. Therefore, at the lack of incentive, there can be a temptation for a manager to slack. Additionally, they can be tempted to waste firm’s money on their own private benefits. For example, buying corporate jets or scheduling business meetings in a fancy resort seldom increase the firm’s value. Failing project can hurt manager’s position and reputation. If there is no incentive for risk taking for managers, they probably start to prefer safer projects that can hinder the company’s growth. There is also chance of “empire building”, which means that company begins to acquire other companies, which increases the size of a company, instead of raising the profits (Baker & Kiymaz 2011). This benefits usually more managers by lifting their status, perks, reputation and compensation, but at the cost of efficiency and value of a company. To prevent this to happen, principals have to monitor and measure the firms and its managements’ performance, which also causes costs.
There legal and regulatory requirements, which reduce agency costs; it is managers’
duty to act responsibly and in the interest of owners. It is also prohibited to inside trade and these are monitored by the government and financial authority. Monitoring adds direct agency costs, because financial statements must be audited. Company wants to pass the audition, because otherwise auditor issues a qualified opinion, which means that everything is not right. This result is usually bad news for the firm and for its value.
Lenders are also constantly monitoring the firm and issue covenants to protect their loans. Covenant usually demands the firm to maintain certain level of gearing. Breaking the covenant can result lender to call back the obligation, but it is more probable to just re-negotiate the terms of the debt, which results to higher interests. (Jensen & Meckling 1978; Fama & Jensen 1983)
Board of Directors is elected by the shareholders, and their job is to keep eye of the management. Especially large institutional investors monitor firm performance closely and sometimes even demand their own representatives to join the board. Shareholders can also pressure the firm by just walking away from the company, which results fall in the firm’s value. Still the most common way to ensure managements incentive to maximize company’s value is stock options. This makes sure that management strives to add value, because otherwise the options would be worthless. However, there is still possibility that management just tries to pump up the stock with short term decisions, which could hurt the company in the long run. Therefore, as studies show, family firms succeed best on the long run, as their management owns a large portion of the firm and the firm is a kind of heritage that must be cherished. (Brealey et al. 2011; Jensen &
Meckling 1978; Fama & Jensen 1983)
Market value
D/E 𝑉𝑈
PV tax shield
PV financial distress
Optimal debt
Agency & financial distress costs
Figure 5. Agency costs. (Niskanen & Niskanen 2000: 293.)