Showing papers on "Agency cost published in 2000"

Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure

Abstract: This paper integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. We define the concept of agency costs, show its relationship to the ‘separation and control’ issue, investigate the nature of the agency costs generated by the existence of debt and outside equity, demonstrate who bears costs and why, and investigate the Pareto optimality of their existence. We also provide a new definition of the firm, and show how our analysis of the factors influencing the creation and issuance of debt and equity claims is a special case of the supply side of the completeness of markets problem. The directors of such [joint-stock] companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. — Adam Smith (1776)

Agency Costs and Ownership Structure

Abstract: We provide measures of absolute and relative equity agency costs for corporations under different ownership and management structures. Our base case is Jensen and Meckling’s ~1976! zero agency-cost firm, where the manager is the firm’s sole shareholder. We utilize a sample of 1,708 small corporations from the FRB0NSSBF database and find that agency costs ~i! are significantly higher when an outsider rather than an insider manages the firm; ~ii! are inversely related to the manager’s ownership share; ~iii! increase with the number of nonmanager shareholders, and ~iv! to a lesser extent, are lower with greater monitoring by banks. THE SOCIAL AND PRIVATE COSTS OF AN AGENT’S ACTIONS due to incomplete alignment of the agent’s and owner’s interests were brought to attention by the seminal contributions of Jensen and Meckling ~1976! on agency costs. Agency theory has also brought the roles of managerial decision rights and various external and internal monitoring and bonding mechanisms to the forefront of theoretical discussions and empirical research. Great strides have been made in demonstrating empirically the role of agency costs in financial decisions, such as in explaining the choices of capital structure, maturity structure, dividend policy, and executive compensation. However, the actual measurement of the principal variable of interest, agency costs, in both absolute and relative terms, has lagged behind. To measure absolute agency costs, a zero agency-cost base case must be observed to serve as the reference point of comparison for all other cases of ownership and management structures. In the original Jensen and Meckling agency theory, the zero agency-cost base case is, by definition, the firm owned solely by a single owner-manager. When management owns less than 100 percent of the firm’s equity, shareholders incur agency costs resulting from management’s shirking and perquisite consumption. Because of limitations imposed by personal wealth constraints, exchange regulations on the minimum numbers of shareholders, and other considerations, no publicly traded firm is entirely owned by management. Thus, Jensen and Meckling’s zero agency cost base case cannot be found among the usual sample of publicly

Firm Size and Cyclical Variations in Stock Returns

Abstract: Recent imperfect capital market theories predict the presence of asymmetries in the variation of small and large firms' risk over the economic cycle. Small firms with little collateral should be more strongly affected by tighter credit market conditions in a recession state than large, better collateralized ones. This paper adopts a flexible econometric model to analyze these implications empirically. Consistent with theory, small firms display the highest degree of asymmetry in their risk across recession and expansion states, which translates into a higher sensitivity of their expected stock returns with respect to variables that measure credit market conditions. RECENT IMPERFECT CAPITAL MARKET THEORIES (e.g., Bernanke and Gertler (1989), Gertler and Gilchrist (1994), Kiyotaki and Moore (1997)) predict that changing credit market conditions can have very different effects on small and large firms' risk. Agency costs induced by asymmetry in the information held by firms and their creditors make it necessary for firms to use collateral when borrowing in the credit markets. Small firms, it is argued, typically do not have nearly as much collateral as large firms and will not have the same ability to raise external funds. Therefore, small firms will be more adversely affected by lower liquidity and higher short-term interest rates. Such theories do not simply have the cross-sectional implication that small firms' risk will be more strongly affected by tighter credit markets in all economic states. Based on the idea that a decline in a borrower's net worth raises the agency cost on external finance, the theories identify asymmetries in the effect of tighter credit market conditions on risk during recessions and expansions. In a recession, small firms' net worth, and hence their collateral, will be lower than usual and tighter credit markets will be associated with stronger adverse effects than during an expansion when the collateral of these firms is higher. Large firms are less likely to experience similarly

Stock Pyramids, Cross-Ownership, and Dual Class Equity: The Mechanisms and Agency Costs of Separating Control from Cash-Flow Rights

Abstract: This paper examines common arrangements for separating control from cash flow rights: stock pyramids, cross-ownership structures, and dual class equity structures. We describe the ways in which such arrangements enable a controlling shareholder or group to maintain a complete lock on the control of a company while holding less than a majority of the cash flow rights associated with its equity. Next, we analyze the consequences and agency costs of these arrangements. In particular, we show that they have the potential to create very large agency costs -- costs that are an order of magnitude larger than those associated with controlling shareholders who hold a majority of the cash flow rights in their companies. The agency costs of these structures, we suggest, are also likely to exceed the agency costs of attending highly leveraged capital structures. Finally, we put forward an agenda for research concerning structures separating control from cash flow rights.

On the Economics and Politics of Corporate Finance and Corporate Control

Abstract: The paper reviews and assesses our understanding of the relation between cor-porate finance and corporate control. It questions the significance of the notion that entrepreneurs or managers give up significant powers of control in order to obtain external finance, arguing instead that (a) entrepreneurs or managers are reluctant to give up control rights for finance and (b) such exchanges are not credible because entrepreneurs or managers have "residual" means of reneging on such exchanges if they want to. This view leads to a reassessment of the role of the financial system as channelling funds from firms with surplus cash to firms with "surplus" investment needs rather than channelling funds from hou-seholds to firms. The paper asks what agency problems and biases this involves, with particular focus on the scope for structural change when cash flows and investment opportunities are not well correlated. The last part of the paper discusses the politics of corporate control with a view to the natural alliance between (i) the political system supporting incumbent management's claims to retain control and (ii) corporate management with discretion over the use of "free cash flow" to provide funding for matters of political interest outside of regular public budgeting procedures.

Corporate Governance and Firm Diversification

Abstract: We empirically investigate whether corporate governance structure is different between focused and diversified firms, and whether any differences in corporate governance are associated with the value loss from diversification. We find that, relative to focused firms, CEOs in diversified firms have lower stock ownership and lower pay-for-performance sensitivities. Diversified companies, however, have more outside directors, no difference in independent block-holdings, and sensitivity of CEO turnover to performance similar to that in single-segment firms. Moreover, we find no compelling evidence that internal governance failures are associated with the decision to diversify, or that governance characteristics explain the value loss from diversification. Our findings suggest that diversified firms use alternative governance mechanisms as substitutes for low pay-for-performance sensitivities and CEO ownership. We conclude that agency costs do not provide a complete explanation for the magnitude and persistence of the diversification discount.

Political Preconditions to Separating Ownership from Corporate Control

Abstract: The large public firm dominates business in the United States despite its critical infirmities, namely the frequently fragile relations between stockholders and managers. Managers' agendas can differ from shareholders'; tying managers tightly to shareholders has been central to American corporate governance. But in other economically-advanced nations ownership is not diffuse but concentrated. It is concentrated in no small measure because the delicate threads that tie managers to shareholders in the public firm fray easily in common political environments, such as those in the continental European social democracies. Social democracies press managers to stabilize employment, press them to forego even some profit-maximizing risks with the firm, and press them to use up capital in place rather than to down-size when markets no longer are aligned with firm's production capabilities. Since managers must have discretion in the public firm, how they use that discretion is crucial to stockholders, and social democratic pressures on managers induce them to stray from their shareholders' preference to maximize profits. Moreover, the means that align managers with diffuse stockholders in the United States--incentive compensation, transparent accounting, hostile takeovers, and strong shareholder-wealth maximization norms--are harder to implement in continental social democracies. Hence, public firms in social democracies will, all else equal, have higher managerial agency costs, and large-block shareholding will persist as shareholders' next best remaining way to control those costs. Indeed, when we line up the world's richest nations on a left-right continuum and then line them up on a close to diffuse ownership continuum, the two correlate powerfully. True, the effects on total social welfare are ambiguous; social democracies may enhance total social welfare, but if they do, they do so with fewer public firms than less socially-responsive nations. We thus uncover not only a political explanation for ownership concentration in Europe, but also a crucial political prerequisite to the rise of the public firm in the United States, namely the absence of a strong social democracy and the concomitant political pressures it would have put on the American business firm.

Managerial Ownership and Accounting Disclosures: An Empirical Study

Abstract: This study examines empirically the effect of managerial ownership on firms' disclosures. Agency theory predicts that investors' information requirements increase with the agency costs of the firm. Managerial ownership mitigates agency costs and therefore should reduce investors' information needs. This study tests the hypothesis that firms with lower levels of managerial ownership provide more extensive disclosures by examining analysts' ratings of firms' disclosures. In contrast to the proxies used in prior studies that test this relationship, such as the earnings-return correlation and management earnings forecasts, these ratings provide a more direct measure of firms' overall disclosure practices. I find that the relationship between managerial holdings and disclosures depends on the type of disclosure. Consistent with the hypothesis of this study, firms with lower levels of managerial ownership are more likely to receive higher ratings for the disclosures provided in their annual and quarterly reports, even after controlling for size, performance, volatility of returns, the frequency of securities offerings and proprietary costs. The more informal and flexible aspects of disclosures, however, as measured by the investor relations rating, are not influenced by the level of managerial ownership. These results are consistent with prior research that predicts that firms lower their costs of capital by signaling a commitment to maintain a more open disclosure policy. Because annual and quarterly reports are less flexible, and therefore less likely to change, they may represent a more credible commitment to provide more informative disclosures.

Security Analysis, Agency Costs, and Company Characteristics

Abstract: We appraise the monitoring activity of security analysis from the perspective of the manager–shareholder conflict. Using a data set of more than 7,000 company-year observations for manufacturing companies tracked by security analysts over the 1988–94 period, we found that security analysis acts as a monitor to reduce the agency costs associated with the separation of ownership and control. We also found, however, that security analysts are more effective in reducing managerial non-value-maximizing behavior for single-segment than for multisegment companies. In addition, the shareholder gains from the monitoring activity of security analysis are larger for single-segment than for multisegment companies.

Private Predecision Information, Performance Measure Congruity, and the Value of Delegation*

Abstract: We use a linear contracting framework to study how the relation between performance measures used in an agent's incentive contract and the agent's private predecision information affects the value of delegating decision rights to the agent. The analysis relies on the idea that available performance measures are often imperfect representations of the economic consequences of managerial actions and decisions, and this, along with gaming possibilities provided to the agent by access to private predecision information, may overwhelm any benefits associated with delegation. Our analytical framework allows us to derive intuitive conditions under which delegation does and does not have value, and to provide new insights into the linkage between imperfections in performance measurement and agency costs.

On the demand for corporate property insurance

Abstract: Since changes in the firm-specific or unsystematic risks faced by a corporation have no effect on firm value, corporate insurance purchases might seem unwarranted. However, more than 57 percent of insurance premiums are paid by businesses. This apparent contradiction has motivated researchers to suggest factors other than simple risk reduction that create corporate incentives to purchase insurance. This article tests the practical validity of most of the analytic arguments regarding corporate demand for insurance. In general, the empirical evidence from corporate property insurance purchases is consistent with the various theoretical arguments regarding corporate demand for insurance. The results suggest insurance helps to reduce various agency costs associated with stakeholder conflicts, provides real services, and reduces taxes. Finally, the less risky nature of regulated industries compared with unregulated industries is believed to lessen the various corporate incentives to purchase property insurance.

Asset Substitution, Debt Pricing, Optimal Leverage and Maturity

Abstract: I suggest a continuous time model for debt and equity valuation where leverage and maturity structure are chosen optimally by the firm's management. The capital structure decision involves trading off the tax benefits of leverage, financial distress costs and the agency costs associated with risk shifting incentives. Closed form solutions for the values of corporate securities, the levered firm and agency costs are obtained. I provide quantitative illustrations of how the capital structure decision is influenced by the potential for asset substitution. I show that in a typical scenario, a firm could afford to take on an additional 20% of leverage and use distinctly longer term debt maturity if asset substitution were ruled out. Furthermore I show that when deviations from the Absolute Priority Rule in bankruptcy are present, management is encouraged to increase risk ex post but will compensate ex ante by reducing leverage and using shorter maturity debt.

Providing Managerial Incentives: Cash Flows versus Accrual Accounting

Abstract: This paper analyzes a principal-agent model in which the agent (manager) can exert effort in every period in order to gain access to some investment opportunity. He or she then decides whether the firm undertakes the opportunity. My analysis focuses on satisfactory incentive schemes which motivate the manager to exert effort and to invest in all profitable projects. As a consequence, the principal's gross benefit is held fixed, and the variable of interest is the resulting agency cost, i.e., the present value of all compensation payments to the manager. The manager's compensation payments are based on a performance measure chosen by the principal. My analysis compares performance measures based only on realized cash flows with the residual income performance measure. I assume that the calculation of residual income is based on depreciation charges which reflect the useful life of assets as well as the intertemporal distribution of cash flows generated by those assets. For suitably chosen depreciation charges, residual income reflects at each point in time the value currently created by the manager.

Corporate Finance and State Enterprise Reform in China

Abstract: This paper uses a novel approach in addressing two puzzles in the field of corporate finance in China, where government is a major player. In addition to the traditional approach based on agency theory and information asymmetry, the paper uses the political costs approach in studying the stock dividend puzzle and rights issues puzzle. The paper finds that the extent of political interference, managerial entrenchment and institutional control affect corporate financing choices and dividend distribution decisions. The result sheds new light on improving the important corporate finance aspects of state enterprise reform in China.

Do IPO Charters Maximize Firm Value? Antitakeover protection in IPOs

Abstract: This paper focuses on the widely held views that: (a) antitakeover provisions (ATPs) increase agency costs, thereby reducing firm value; and (b) firms going public minimize agency costs, thereby maximizing firm value. We show that these views cannot comfortably co-exist: ATPs are common in a sample of IPO-stage charters. Moreover, ATP use is not explained by two efficiency explanations of ATP use with theoretical support - target firms' need for bargaining power when a bid is made and the threat of managerial myopia. Rather, we find that antitakeover protection is used to protect management when takeovers are most likely and management performance most transparent. ATP use, however, is uncorrelated with a proxy for high private benefits.

Executive Incentive Compensation Schemes and their Impact on Corporate Performance: Evidence from New Zealand Since Legal Disclosure Requirements Became Effective

Abstract: For many years, executive compensation has been regarded as an internal mechanism to alleviate the agency problems between executives and shareholders. Using a sample of 73 New Zealand listed companies (1994-1998), this paper examines the current state of executive compensation in New Zealand and the relationship between executive incentive compensation and firm performance. The empirical results concerning the relationship between executive compensation and corporate performance indicate that company size and business risk are important factors affecting executive compensation level. The results also show that neither compensation level nor the adoption of an incentive compensation scheme (ICS) are significantly related to corporate performance. However, the relationship between Tobin's q and executive share ownership is found to be strong and statistically significant, while the relationship is found to be insignificant when ROE and ROA are used as a proxy for corporate performance. These negative results suggest that the design of the executive compensation contract has not yet contributed to the reduction of agency costs for companies in New Zealand.

An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives, and the Creditors' Bargain

Abstract: This paper argues that the UK's wrongful trading provisions, enshrined in section 214 of the Insolvency Act 1986, are meant to ensure that hopelessly troubled companies enter the insolvency forum at the optimal time. This forum enables -- and forces -- those interested in the company's undertaking to forego aggressive and value-destroying individual action. Put differently, one of the functions of the collective insolvency regime is to minimise the co-ordination costs of the creditors of a firm threatened with insolvency. Section 214 is a tool enabling the regime to take over when these costs would be most acute. The existence of the collective regime might itself create motivation costs by producing incentives for parties who would lose out under it to try to prevent the company becoming subject to it. Directors would act for themselves and on behalf of shareholders to keep the firm out of the insolvency forum. The central insight offered into section 214 here is that the section assists in overcoming the co-ordination costs of creditors by controlling creditor/manager agency costs on the eve of insolvent liquidation.The analysis in this paper operates on two levels. First, this paper shows that the wrongful trading provisions would be voluntarily accepted by all the relevant parties given the chance to bargain ex ante. Here, all the parties anticipate the incentives of managers to misbehave towards creditors when their firm is on the brink of insolvent liquidation. A provision like section 214 bonds managers to creditors when the firm is terminally distressed, and thus signals the credit and labour markets not to penalise shareholders and managers. On the other hand, where a market solution is available -- as it is in the shape of the discipline imposed by the market for managerial labour, and the existence of security -- the section 214 bond takes the back seat. On this basis, this paper suggests that wrongful trading claims would generally be brought against shareholder-managers of closely-held companies, and shadow directors, and examines "impressionistic" evidence which is not inconsistent with this hypothesis. It is shown that on this analysis, the English Court of Appeal's well-known decision in Re Oasis, directing section 214 recoveries away from secured creditors, is perfectly reasonable.On another level, the well-established Law and Economics proposition -- that to redistribute in insolvency leads to perverse incentives -- is challenged. It is argued that the wrongful trading provisions are redistributive. They strip away the benefit of limited liability from the insolvent company's directors, making their assets vulnerable to a claim by the liquidator on behalf of the company's unsecured creditors. This takes place only within the specialised insolvency forum, and only because the distinct insolvency regime creates new rights and liabilities which are incapable of existing while the company is still solvent. Three types of perverse incentive which might potentially lead to unnecessary motivation costs are described. The analysis suggests that, far from creating perverse incentives, section 214 in fact encourages directors of troubled and healthy companies alike to operate with some much-needed regard for the company's unsecured creditors.

When Financial Intermediaries are Corporate Owners: An Agency Model of Institutional Ownership

Abstract: Increasingly, the equity investments of individual investors are being channeled through financial institutions. This article posits that the role of institutional owners as financial intermediaries, and the resulting complexity that institutions bring to ownership, distinguish institutional ownership from individual ownership. I develop a model of institutional ownership, referred to as the nexus agency model (NAM), which reflects this complexity. The model provides a framework for identifying the potential additional agency costs to beneficial owners that are associated with owning via financial institutions. The degree to which owning via institutions benefits individual owners depends on the adequacy of the legal and regulatory environment and governance mechanisms in protecting individual owners' interests. The applicability of the nexus model to different institutional owner types is then demonstrated in a discussion of U.S. public and private pension plans and mutual funds, leading to the generation of a NAM-based research agenda for each type and across the types. The article ends with discussion of the model's applicability to non-U.S. institutional environments.

An Agency Cost Analysis of the Wrongful Trading Provisions: Redistribution, Perverse Incentives, and the Creditors’ Bargain

Abstract: Previous work on the wrongful trading provisions of the Insolvency Act 1986 (s. 214) has been content with description, or with statutory construction. This paper employs the tools of agency theory and the creditors' bargain heuristic to analyse the need for these provisions, their structure, role, and effect. It examines why those interested in the company's undertaking would demand and accept a s. 214-type duty. The analysis reveals that the duty would not be equally relevant for all types of companies, and that the influence of the market for managerial labour ensures most s. 214 actions are likely to be brought against directors of closely-held companies, and against shadow directors. The analysis, by pointing out that security plays a role similar to s. 214 itself, also justifies a recent Court of Appeal decision which precludes secured creditors from any recoveries under that section. Finally, the incentives created by the provisions for the managers of both healthy and distressed companies are examined. It is suggested that these incentives are generally socially efficient.

Private Pre-Decision Information, Performance Measure Congruity and the Value of Delegation

Abstract: We use a linear contracting framework to study how the relation between performance measures used in an agent's incentive contract and the agent's private pre-decision information affects the value of delegating decision rights to the agent. The analysis relies on the idea that available performance measures are often imperfect representations of the economic consequences of managerial actions and decisions, and this, along with gaming possibilities provided to the agent by access to private pre-decision information, may overwhelm any benefits associated with delegation. Our analytical framework allows us to derive intuitive conditions under which delegation does and does not have value, and to provide new insights into the linkage between imperfections in performance measurement and agency costs. Key Words: Private pre-decision information; Performance measure congruity; Delegation

Incentive Compensation and the Stock Price Response to Dividend Increase Announcements

Abstract: Linking executive compensation to stock price performance is predicted to decrease the usual positive price response to dividend increases for two reasons. One, increasing pay-performance sensitivity (PPS) exacerbates managers' optimistic bias regarding future firm performance, reducing the credibility of dividend signals. Two, increasing pay-performance sensitivity reduces the need for dividends as a means of reducing agency costs. Consistent with behavioral and agency theories of corporate finance, we find that price response does decrease as pay-performance sensitivity increases and that this effect is concentrated in firms with low market-to-book ratios. Additional findings are most consistent with the agency cost explanation.

The Parent Company Puzzle: When is the Whole Worth Less Than One of Its Parts

Abstract: This paper examines seven instances in which the market value of a parent company was less than the market value of its holdings of a publicly traded subsidiary Efforts are made to explain this "parent company puzzle" in terms of taxes, agency costs, liquidy effects and noise trader risk None of them work The only explanation consistent with the evidence is a mispricing of the subsidiary shares associated with a downward sloping demand curve As further evidence in support of this view, five corporate control transactions, all designed to exploit the apparent mispricing, were initiated while this research was in progress

An Agency Analysis of Firm Diversification: The Consequences of Discretionary Cash and Managerial Risk Considerations

Abstract: Firm diversification is shown to be a function of excess discretionary cash flow and managerial risk considerations. We measure firm diversification using the concentric diversification index. The index is positively related to both the number of business units in the firm and the extent to which the business firm's segments differ. Consequently, the measure provides a proxy for how firm diversification decisions impact the risk of the firm, and the measure is found to be inversely related to both total risk and unsystematic risk. Consistent with the agency arguments of discretionary cash flow, we find the level of excess discretionary funds in the firm to be a significant positive determinant of the level of firm diversification. We also find support for both a wealth transfer hypothesis over low levels of managerial ownership, and a managerial risk aversion hypothesis over high levels of managerial ownership.

Excessive Continuation and Dynamic Agency Costs of Debt

Abstract: This paper analyses the incentives of the equityholders of a leveraged company to shut it down in a continuous time, stochastic environment. Keeping the firm as an ongoing concern has an option value but equity and debt holders value it differently. Equityholders' decisions exhibit excessive continuation and reduce firm's value. Using a compounbd exchange option approach, we characterise the resulting agency costs of debt, derive the "price" of these costs and analyse their dynamics. We also show how agency costs can be reduced by the design of debt and the possibility of renegotiation.

Agency Costs, Institutions, Learning and Taxation in Venture Capital Contracting

Abstract: This paper introduces a dataset on forms of finance used in 12,363 Canadian and US venture capital and private equity financings of Canadian entrepreneurial firms from 1991 to 2003. The data comprise different types of venture capital institutions, including corporate, limited partnership, government and labour-sponsored funds, as well as US funds that invest in Canadian entrepreneurial firms. Unlike prior work with US venture capitalists financing US entrepreneurial firms, the data herein indicate convertible preferred equity has never been the most frequently used form of finance for either US or Canadian venture capitalists financing Canadian entrepreneurial firms, regardless of the definition of the term 'venture capital'. A syndication example and a simple theoretical framework are provided to show the non-robustness of prior theoretical work on optimal financial contracts in venture capital finance. Multivariate empirical analyses herein indicate (1) security design is a response to expected agency problems, (2) capital gains taxation affects contracts, (3) there are trends in the use of different contracts which can be interpreted as learning, and (4) market conditions affect contracts.

Performance Standards and Incentive Pay in Agency Contracts

Abstract: When the presence of limited liability restricts a principal from imposing monetary fines on an agent in case of poor performance, the principal might use other kinds of punishment threats to deter the agent from shirking. We show that under the optimal contract in this case, the principal sets a performance standard and punishes the agent if the standard is not met, but rewards the agent on a profit-sharing basis if the standard is significantly exceeded. The optimal choice of performance standards for such contracts is discussed. It is shown that punishment threats, although inefficient, often help the principal to discipline the agent. JEL classification: D82