Showing papers on "Agency cost published in 1992"

INSIDERS AND OUTSIDERS: The Choice between Informed and Arm's-length Debt

Abstract: While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profits, once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks. ACCORDING TO RECEIVED THEORY, banks reduce the agency costs associated with lending to small and medium growth firms in various ways.' Yet in practice, many such firms diversify away from bank financing even if banks are willing to lend more.2 Why do these firms forsake informed and seemingly more efficient sources of debt finance to borrow from less informed arm's-length sources? While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decision which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profits, once projects have begun. The firm's choice of borrowing sources and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks.

Executive Incentive Plans, Corporate Control, and Capital Structure

Abstract: Agency theory recognizes that the interests of managers and shareholders may conflict and that, left on their own, managers may make major financial policy decisions, such as the choice of a capital structure, that are suboptimal from the shareholders' standpoint. The theory also suggests, however, that compensation contracts, managerial equity investment, and monitoring by the board of directors and major shareholders can reduce conflicts of interest between managers and shareholders. This research investigates the relationship between the firm's capital structure and 1) executive incentive plans, 2) managerial equity investment, and 3) monitoring by the board of directors and major shareholders. This paper finds a positive relationship between the firm's leverage ratio and 1) percentage of executives' total compensation in incentive plans, 2) percentage of equity owned by managers, 3) percentage of investment bankers on the board of directors, and 4) percentage of equity owned by large individual investors. These findings are consistent with the predictions of agency theory, suggesting, in turn, that capital structure models that ignore agency costs are incomplete.

Measuring the Agency Cost of Debt

Abstract: We adapt a contingent claims model of the firm to reflect the incentive effects of the capital structure and thereby to measure the agency costs of debt. An underlying model of the firm and the stochastic features of its product market are analyzed and an optimal operating policy is chosen. We identify the change in operating policy created by leverage and value this change. The model determines the value of the firm and its associated liabilities incorporating the agency consequences of debt. THE OPTIMAL CAPITAL STRUCTURE for a firm is now widely regarded to be determined by a broad range of factors including a mix of tax effects, the various agency problems associated with different securities, and the various costs of issuing securities, including the costs created by adverse selection. While the existence of a theoretical optimum has been demonstrated in a variety of papers, a less explored area has been the construction of detailed models that enable us to measure each of the relevant factors for a particular company and thereby to determine the actual optimal mix for that firm. This gap in our understanding is particularly glaring in the case of agency costs. In order to allow a careful modelling of strategic relations, the parameters of most agency models are either so simplified that it is impossible to associate them with measurable parameters of a real world case, or else the models simply abstract from certain critical factors-such as a robust measure of price risk-that must be incorporated into any real application. For example, although we now understand that sinking funds, dividend restrictions, and other bond covenants help to resolve the conflict of interest between bondholders and equity, we do not yet have much in the way of models with which to determine the optimal parameters of these very covenants. Contingent claims models can provide a consistent framework for multiperiod valuation that properly accounts for risk, but they usually abstract from the agency factors entering capital structure decisions. When using a contingent claims model to value a firm's securities it is common to take the value of the firm itself as governed by an exogenously defined stochastic process. The value of the firm's securities are then derived from this underlying value, and, as Merton (1974) points out in his paper on the pricing of risky debt, the Modigliani-Miller theorem obtains so that the value of the firm is independent of the value and the type of debt. In order to apply the contingent claims techniques to a setting in which agency problems are central, some adaptation is necessary. In this paper we

Underwriter Compensation and Corporate Monitoring

Abstract: Studies suggest that underwriting syndicates provide marketing services and certify the fairness of offer prices. We argue that syndicate lead banks also monitor manager effort, increasing the value of capital-raising companies. A given level of monitoring is associated with a given level of intrinsic value, so there is a "schedule" of certifiable offer prices, depending on the level of monitoring. Monitoring, marketing, and certification are, therefore, all legitimate syndicate functions. New evidence supporting the conclusion that syndicates provide corporate monitoring is presented. PRIOR STUDIES SUGGEST THAT underwriting syndicates provide marketing and certification services for capital-raising companies. Marketing services include searching the primary market and compensating buyers for their costs of providing funds (see Kraus and Stoll (1972), Hansen and Pinkerton (1982), and Mikkelson and Partch (1985)). For convenience, risk bearing is categorized as a marketing service. Certification is bearing the liability imposed by the Securities Act of 1933 for the "fairness" of the offer price. In this article we examine whether the lead investment banks of underwriting syndicates also provide monitoring of corporate managers and affairs. This idea is implicit in Easterbrook's (1985) theory that corporate payouts raise company value because they can elicit investment bank monitoring of the company. In our theory, lead bank monitoring improves corporate performance and reduces agency costs, thereby raising the company's intrinsic value. In consequence, a given level of monitoring is associated with a given level of intrinsic value, resulting in the possibility of several certifiable offer prices. Top managers demand lead bank monitoring because it adds value. The behavior of their demand reflects that lead bank monitoring substitutes for other monitoring and that managers avoid monitoring out of self-interest. But we argue that avoidance of monitoring is publicly observed and will thus subject managers to potentially greater penalties than those that might be meted out as a result of lead bank monitoring. Therefore, we suggest that the substitu

Why Hang on to Losers? Divestitures and Takeovers

Abstract: We study the divestiture decisions of managers who care about their reputations. Managers' divestiture and investment decisions are publicly observable, but managers privately observe signals with respect to the future payoff distribution of investments they have initiated. We establish that in equilibrium there is too little divestiture. These inefficiencies create the opportunity for wealth-enhancing divestiture-motivated takeovers. A key result is that only managers of targets with "middle of the road" asset specificity should consider the takeover threat credible. These findings suggest that uniqueness of assets is an important determinant of both agency costs and takeover activity. Our analysis leads to several empirical predictions. OVERWHELMING EMPIRICAL EVIDENCE HAS documented large gains in shareholder wealth that arise from takeovers (Jarrell, Brickley, and Netter (1988), and Jensen and Ruback (1983)). The source of these gains has remained elusive, however. Although takeovers are followed by some infusion of new managerial talent, we have not witnessed the kind of profound post-takeover restructuring of the productive activities of target firms that would readily justify the documented wealth gains. A commonly observed post-takeover initiative is divestiture of some of the target's lines of business (Bhide (1989), and Bhagat, Shleifer, and Vishny (1990)). What is puzzling is that if the gains from takeovers stem from the anticipation of such divestitures, then why were these divestitures not undertaken by the target firm's management in the first place? The purpose of this paper is to provide a possible answer to this question. Our focus is on the divergence in incentives between managers and shareholders with respect to divestitures of ongoing projects. We show that managers might rationally decide to hang on to projects that should be divested in

Managerial compensation and the agency costs of debt finance

Abstract: This paper presents a model of the agency costs of debt finance, based on the conflict of interest between shareholders and bondholders. We show how the terms of the compensation contract offered to management by shareholders can reduce these agency costs. We derive a managerial compensation contract that restores the first-best outcome and leads to a local irrelevance result for financial structure. More generally, the model points out that the nature of managerial compensation contracts will affect the firm's optimal financial structure, and offers a reason why managerial compensation is typically not closely correlated with shareholder returns.

An Ecology of Agency Arrangements: Mortality of Savings and Loan Associations, 1960-1987

Abstract: Hayagreeva Rao Emory University Eric H. Neilsen Case Western Reserve University This paper examines whether organizations with different collectivized agency arrangements have different survival prospects. We propose that the structure of monitoring and incentive systems determines the agency costs of collectivized agencies and, in turn, their vulnerability to competition and environmental variability. The paper focuses on mutual and stock savings and loan associations (SLAs) and notes that stock SLAs have superior monitoring, incentive systems, and capital structures in comparison with mutual SLAs. An analysis of 900 SLAs founded during 1960-1987 indicates that mutual companies were more vulnerable than stock companies to competition from commercial banks, but there was no conclusive evidence that mutuals were more susceptible to environmental variability than stocks were. The results also show that deregulation sharply attenuated the agency advantages of stocks, implying that agency-cost advantages may be constrained by institutional processes.'

Corporate Investment Decisions and Corporate Control: Evidence from Going-Private Transactions

Abstract: The investment decisions of firms over a five-year period immediately prior to being taken private are examined. The results indicate that announcements of new investments made by going-private candidates are characterized by significant negative median abnormal returns. These findings appear to be driven largely by the subsample of contested transactions. For this subsample and its control group, the likelihood of becoming a buyout candidate is significantly inversely related to the wealth effects of the firm's investment decisions. Overall, the results suggest that one source of value in going-private transactions, particularly contested transactions, is the reduction of agency costs observed in the form of poor investment decisions.

Executive compensation and the performance of the firm

Abstract: A sample of large industrial corporations is examined to determine whether there is a relationship between the levels of compensation received by the senior executives of those firms and the firms' economic performances. We find consistent evidence of such a relationship, with differences across firms in the total compensation of their three highest-paid officers being positively related to differences in both the common stock returns and operating profitability of the firms. The implication is that compensation packages are designed to reduce agency costs.

Corporate Control, Portfolio Choice, and the Decline of Banking

Abstract: The authors focus on the persistence of bank unprofitability during the 1980s. A large literature in banking, following Merton (1977), concentrates on the incentives of shareholders to maximize the value of the (fixed rate) deposit insurance subsidy provided by the government by taking on risk inefficiently, so called moral hazard' risk. This paper takes issue with this moral hazard explanation for the performance of the banking industry. The moral hazard view assumes that shareholders make the lending decisions and can take on risk to maximize the value of insurance if they desire. The authors assume bank managers, who may own a fraction of the bank, make the lending decisions. If managers have different objectives than outside shareholders and disciplining in managers is costly, then managerial decisions may be at odds with the decisions outside shareholders would like them to take. When investment opportunities are declining, managers behave differently than in healthy' industries. This is particularly true in banking, where asymmetric information and deposit insurance allow banks resources to invest even if there are few good lending opportunities. The risk-avoiding behavior of managers stressed in the corporate finance literature presumes that conservative behavior is sufficient for job and perquisite preservation. When bad managers predominate, conservative behavior may not allow most managers to keep their jobs and perquisites. These managers may find it optimal to take excessively risky actions. The paper sets out a game between a bank manager and shareholders and solves for a sequential Nash equilibrium. A bank manager chooses either risky or safe loans based on the quality of the loan opportunities available to the manager (the manager s type). The choice of loan portfolios is observed by shareholders, but the manager s type is not. If the manager is fired, shareholders decide whether to invest in new bank assets (hire a new manager) or move their capital out of banking (liquidate capital). In any period that they are employed, managers receive a private benefit. Using data on the equity ownership structure of large bank holding companies, the authors test the predictions of the corporate control model of banking against an alternative model based on moral hazard problems between banks and regulators. With respect to the choice of loans made, the authors findings are consistent with corporate control problems playing an important role, but are inconsistent with moral hazard playing a dominant role in banking. None of the results are what a moral hazard model would predict. However, the analysis is done for adequately-capitalized banks. Thus, if the value of bank equity is low enough, the interests of inside and outside owners are aligned, so there are no corporate control problems of the sort modeled by the authors. It may be accurate to say that, for large U.S. banks, corporate control problems have been the cause of the conditions of which moral hazard may be an accurate characterization. The presence of agency costs suggests that the underlying trends that reduced profitability in the 1980s may persist, despite high bank earnings in the early 1990s. That banking is regulated does not appear to be a sufficient countervailing force. To the extent that chartered banks must transform themselves into nonbanks as they seek nonlending and deposit-taking activities which are profitable, the authors suggest that banking' is in decline. Their conclusions concern the difficulties that outside equityholders face during the transition period.

Incentive effects and managerial compensation contracts: a study of performance plan adoptions.

Abstract: This study examines the relation between manager-shareholder agency costs and the decision to adopt a long-term performance plan. It is argued that firms with mature investment opportunity sets ado...

Leveraging the underinvestment problem: how high debt and management shareholdings solve the agency costs of free cash flow

Abstract: It is argued that leveraged buyouts (LBOs) provide managers with a powerful incentive to release excess cash rather than invest in negative net present value projects. This incentive is attributed to the large debt obligations associated with “junk” bond financing and to an increase in the shareholdings of top management. In this paper I explore the conditions under which leverage and management shareholdings complement one another in resolving the agency costs of free cash flow and would therefore optimally be used “together” as in an LBO. Complementarity is shown to obtain under plausible conditions, essentially because increased leverage reduces equityholders' share of investment returns. Increased management shareholdings then leverage this underinvestment effect. My analysis also helps explain why top managers who participate in an LBO receive a highly leveraged equity claim rather than a share of the “strip” that is generally provided to outside investors.

Agency costs, property rights, and the evolution of labor unions

Abstract: Collective bargaining requires that an agent represent workers. This paper examines the implications for the trade union movement of the resulting agency costs. Without transferable rights in the union, union members lack the means and incentive to bring forth the innovative agent controls common to the modern corporation. Considerations of the bargaining strengths of employers and employees, each represented by an agent, provide an explanation of the simultaneous decline of private sector union membership (corporate share holders have been more successful at lowering agency costs) and growth of public sector union representation (where the union official, a “double agent,” serves the interest of both employee and bureaucratic employer).

Agency costs in U.S. manufacturing: An empirical measure using X-efficiency

Abstract: By adapting the concept of X-inefficiency, the deadweight cost associated with agency problems is estimated for U.S. manufacturing industry. X-inefficiency theory postulates that agent’s opportunistic behavior will lead to second-best outcomes in imperfect markets. When the methodology is applied to the 1986/87 fiscal year, thirty industries are identified as X-inefficient. The total deadweight agency cost generated by these industries amounts to some $76 million. On average, in any given industry, agency costs represent two-tenths of one percent of that industry’s annual sales.

Exploring New Markets : The Multinational Firm's Choice of Direct Investment versus Licensing

Abstract: This paper contributes to a literature which seeks to understand the nature of overseas investments by multinationals, but sheds light on the more general problem facing firms confronting new markets. The firm is assumed ignorant of the state of demand in the new market, a problem given the existence of large fixed and prtially sunk costs of opening a new plant or sales branch. The firm's alternative is to use an informed agent who is currently producing or selling related products in that market. The agent understands that he will be dumped if he reveals that the state of demand is high. This sets up a contracting problem in which the firm must share rents with the agent in the first period in order to extract the information about the true state of demand. The optimal contract and the implied level of agency costs are analyzed. If the level of agency costs are high, inefficient direct investment may take place.

Ownership structure, value of the firm and the bargaining power of the manager

Abstract: In their seminal article, Michael Jensen and William Meckling developed a theory of the corporate ownership structure that took into account "the trade-offs available to the entrepreneur-manager between inside and outside equity and debt" [5, 312]. Jensen and Meckling concentrated on the principal-agent problem and the agency costs that arise from the introduction of outside equity into the firm. This was done without any consideration of what effects such an action might have had on the bargaining power of the owner-manager in negotiating wages with the current employees of the firm. Several years later Masahiko Aoki [1; 2, 61-91] introduced a model of the firm that emphasized "its aspect as a quasi-permanent organization of stockholders and employees" [1, 600]. He asserted that as a result of their association with the firm, the employees acquire skills and knowledge that, when combined with the physical assets supplied by the stockholders, can produce some economic gains-the so-called organizational rent. Such rents would not be possible through the employment of external factors of production (such as workers that have no knowledge of the workings of the firm). The organizational rent can be produced only through the cooperation of the stockholders (supplying the physical assets) and the existing employees. As such, the situation is tantamount to a two-person cooperative game, and the question becomes, how then is the organizational rent to be distributed between stockholders and employees. Aoki proposed that the solution to this particular distribution problem could be accomplished by use of a bargaining process attributed to Frederik Zeuthen and John Harsanyi that leads to the Nash bargaining solution. Implicit in Aoki's analysis was that all equity was outside equity. Therefore, no attention was given to how alternative ownership structures of the firm affect (1) the bargaining power of the manager and (2) the distribution of the organizational rent. One could start out with an ownermanaged firm and examine the distribution of the organizational rent under such an ownership structure. It would then be important to understand how the introduction of outside equity into the firm a lt Jensen and Meckling, would affect, if at all, the distribution of the organizational rent.