Agency theory refers to a contract whereby principals engage with agents to perform some act on their behalf. The act involved giving power to an agent for some decision-making. Everyone work on the feet of benefit that can be gained for oneself. That’s why it is strongly agreed that the agent, as a utility maximizer will not act in the best interest of the principal. Therefore, agents may cheat if they were not monitored by the principal, and the principal, on the other hand, must bear agency costs to avoid suffering loss. These agency costs include monitoring costs of an agent, bonding costs whereby the agent will try to show that they are not self-serving, and residual losses that are too costly to monitor.
In general, agency cost is one of a type of internal cost incurred from or must be paid to, an agent acting on behalf of a principal. Agency costs mainly originated from the separation of control, divergence of ownership and control, and the different objectives (rather than shareholder maximization) of the managers. For example, the difference of interest between shareholders and management. Shareholders hope that management could operate the company in a manner that increases shareholder value. But management may wish to run the company in ways that can maximize their personal authority and well-being that may not be in favor of the shareholders.
Zero agency-cost firms whereby the manager is the firm sole shareholder used as a reference point of comparison for all other cases of ownership and management structures. At one utmost of ownership and management structures are firms whose managers possess 100 percent of the firm. These firms, by their definition, have no agency costs. At the other utmost are firms whose managers are employees with no equity in the firm. In between are firms where the managers possess some, but not all, of their firm’s equity. They stated that agency costs are higher among firms that are not 100 percent owned by their managers and these costs increase as the equity share of the owner-manager declines. In other words, agency costs increase with a reduction in managerial ownership.
In a situation (where the managers own some, but not all, of their firm’s equity) whereby monitoring cost was included by equity holder to alter the opportunity, the owner-manager has for possessing non-monetary benefits can decrease the owner-managers consumption of perquisites. Examples of monitoring costs include auditing and budget restrictions. However, owner-managers will still willingly enter into the contract as it will increase the firm’s value. The particular increase in the value of the firm that accrues will be reflected in the owner’s wealth, but his welfare will be increased by less than this because he forgoes some non-monetary benefits he previously enjoyed.
In a situation (where the managers own some, but not all, of their firm’s equity) whereby owner-manager expands resources to guarantee to equity holder that he would limit his activities, bonding cost incurred. Examples of bonding costs include contractual limitation on the manager’s decision-making power and auditing of the financial account by a public accountant. If the bonding costs were all under owner-managers control, he will gain the benefit as such of monitoring costs gives.
In a nutshell, the manager finds it in his interest to incur these costs as long as the net increments in his wealth which they generate (by reducing the agency costs and therefore increasing the value of the firm) are more valuable than the perquisites given up. Although incurring the monitoring and bonding cost increases the efficiency of the firm, it does not maximize the firm’s value. This is because the cost of separation of ownership and control occurred as a result of differences between the efficient solution of zero monitoring and bonding cost and value of the firm when there is positive monitoring cost. And agency cost will be positive as long as monitoring costs are positive. The size and existence of agency costs depend greatly on the nature of monitoring costs, the needs of managers for non-monetary benefits, and the supply of potential managers who are able to finance the firm with personal wealth.
Agency cost of debt indicates that there will be a rise in the cost of debt when there is a difference in the point of view of bondholders and management. There are a few fractions of agency costs of debts. The first one is the incentive effects related to debts. An owner-manager will intend to involve in investments with high risk and high profits with the financial structure of debt-typed claims because the loss will bear by the debt-holder. For example, where there are two investment options, A and B. Option B will help owner-manager to gain more equity, while option A will give back more profit to bondholder. The choice of investment will only be done after the bonds are sold. Bondholders buy bonds from the company and suppose the company to invest in option A. However, due to the incentive effect, the manager did not invest as they expected but invest in option B which will help them gain more in equity. This will cause welfare loss to the bondholders. However, this decision could be realized by bondholders. If the bondholders knew the choice of the manager, they will only willing to buy the bonds at a lower price. Due to this action, the overall firm value may decrease. This reduction of firm value will be the residual loss which is also known as agency cost. This amount of agency cost is liable to the owner-manager.
Monitoring and bonding costs are another fraction of agency costs. In order to preserve the benefits of their own, bondholders will restrict the management’s decisions. They will set contracts in detail to monitor the owner-managers behavior. The contracts may influence the capacity of the management to make the best decision and decrease the profit of the firm. The decrease of the profit, the cost of enforcing the contracts, and all the other costs related to the contracts are the monitoring costs. As the monitoring costs are borne by the owner-manager, he will hope to minimize the monitoring cost, and therefore he will incur bonding costs. The bonding costs are incurred to give assurance to the bondholder that he will not turn aside from his promised behavior. He will only voluntarily bond himself in the contract when such deed benefits him.
Bankruptcy and reorganization costs are also one of the components of the agency costs of debts. Bankruptcy occurs when the firm unable to pay debt obligations. The cost of bankruptcy is always the interest of the potential buyers of fixed claims. This is because this cost will decrease their payoffs if the bankruptcy happens. If the probability of the bankruptcy cost is high, the willingness of the price buyer to pay for fixed claims will be low. The value lost because of the cost of bankruptcy will be the agency costs. The probability of bankruptcy will negatively affect the operating costs and the incomes of the firm. A firm may need to pay higher salaries in order to keep engaged the employees in the firm when the probability of the firm gone high. Besides, the firms that provide after-sales services will also face a decrease in sales volume.
There are some factors that encourage the firms to use corporate debts although the factors discussed above will discourage them. Tax subsidy on interest payments is one of the factors. There are some theories that verified that the use of risky debt will increase the value of the firm because of the tax subsidy on the interest payments. The firm will enjoy the benefits if, in the end, the benefit of tax subsidy covered the agency costs incurred from debt. Furthermore, the firm will also be motivated to use corporate debt when there is a profitable investment while the firm has insufficient funds to invest. The firm will incur them provided that the profits generated from the investment are greater than the marginal agency costs of debts.
A firm that is facing capital limitation can finance the full capital value of its present and future projects if there are other individuals in the economy who have a large enough amount of personal capital to finance the firm. Besides that, a firm can prevent property losses related to the agency costs due to the sale of debt or outside equity. If not, the firm needs to acquire the excess capital in the debt market with the absence of such individuals. As a result, the owner-manager is the individual who bears the agency costs since the project is unprofitable enough to cover existing costs included agency costs. So, it is important for the owner-manager who bears these costs to reduce the agency costs in order to increase his property.
There are certain risks when the owner-manager demanded outside financing. If the owner-manager is always relying on outside funding, he will have his entire treasure invested in the firm. Therefore, he would not optional for outside funding until he had invested 100 percent of his personal wealth in the firm.
Since the manager invests all of his wealth in a firm, he will bear a welfare loss. However, he can prevent the agency costs when he increasingly relies on outside funding by taking certain actions. If the returns from assets are not totally correlated with the project, an individual can decrease the riskiness of the returns on his part by dividing his treasure into different assets by diversifying. Of course, he will be contributed to becoming a minority stockholder in order to avoid this risk by suffering a wealth loss as he reduces his proportion ownership because prospective shareholders and bondholders will take into account the agency costs.
The analysis of this article is only related to a single investment-financing decision and has excluded the issues of incentives that influencing future financing-investment decisions. However, some changes have been made to conclude that the costs and benefits will be changed by the expectation of future sales of outside equity and debt which may benefit the manager himself. If he brings out a high probability of chance for dealing business, he probably can gain a big amount of future capital from outside sources and it will help to increase the business benefit and reduce the size of the agency costs. But, the finite life of an individual cannot eliminate the agency cost because it needs to consider more on his successors who think of their own benefit and interest.
Normally, they assumed that all outside equity have no right to vote. The manager will suffer the decrease of his partial ownership in the long-run welfare and limit his action to control over the corporation and even fire the manager if they have the right to vote. Besides, if the costs of decreasing the dispersion of ownership are lesser than the benefits to be acquired from decreasing the agency costs, it will pay some individuals to purchase the shares in the market to decrease the dispersion of ownership.
Moreover, they proposed an alternative way for the owner-manager who carried both equity and debt outstanding to get rid of the agency costs of debt. It will be no incentive if he is bound contractually to have a portion of the total debt equal to his partial ownership of the total equity. If the manager is getting the balance between the debt and equity holders, the net effect will be zero. But, the limitation is they have not conducted to the large corporation and just perform in the small company which causes them couldn’t have a clear picture on the formal contract of reducing agency cost.