Agency theory and capital structure: A descriptive study.

Mirza Muhammad Naseer

Mirzamnaseer@gmail.com

Riphah International University, Islamabad, Pakistan.

Abstract

In the finance, the agency theory attempts to describe the behaviors of numerous agents that

mediate in the firm’s funding (managers, stockholders and debt holders) and to evaluate the

influence of these behaviors on the financial structure. In view of the agency theory, the ideal

capital structure comes from settlement among several funding choices like equity, debts and

other securities and that let the settlement of conflicts of interests among the capital providers

(stockholders and debt providers) and managers. The debt allows stockholders and managers

to follow to same intentions, but origins other conflicts between managers and stockholders

one side and creditors on the other side. The ideal level of debt is the one that assure the least

of total agency costs.

Overview

Agency Theory

Agency theory which express that in what manner the executive, manager (agents) perform in

the best interest of owners, shareholders (Principals) of an organization. Theory consider the

relationship wherever in a deal ‘‘one or more persons (the principal(s)) engage another person

(the agent) to perform some service on their behalf which involves delegating some decision

making authority to the agent’’ (Jensen and Meckling, 1976: 308). The agency theory

developed by Jensen and Meckling (1976). Agency theory point out the cost arises due to

conflict of interest among manager, debt holders and equity holders. Jensen and Meckling

(1976) considered the conflict between the shareholder and manager and between shareholders

and bondholders as major type of conflict those will leads to agency problem thus agency cost.

They further stated that agency problem also relative with debt in the shape of risk shifting.

Agency theory with the view that the mangers issue debt instead of shares and bond themselves

to payout future cash flows it is not possible if they distribute the earning in shape of dividend.

Through this they make a promise to debt provider that they will pay the principal plus interest

if they fail to do so the debt provider put the firm in bankruptcy court. Consequently, debt

decrease the agency costs connected with free cash flow by reducing the cash flow that have

to be available for spending based upon the decision of the manager. This influence of debt

reflecting it as the determining element of company financial mix (Jensen, 1986) The agency

theory highlighted that if the company uses more debt as compared to equity company can get

the benefits of tax as the interest payments are tax deductible. In contrast the theory said that

more leverage also involves more cost. The more levered firms have more bankruptcy cost.

Though theory in the view that any firm can only attain the optimal capital structure and

maximize the value by matching debt costs with their benefits (Jensen, 1986).

The agency theory proposes that the firms which having more profitable assets use large

portion of their earning for debt payments thus this will increase their credit rating and they

can increase their debt capacity. In the same way those firm having high profit as compared to

their investment can also get benefits of debts and lessen the issues regarding free cash flow

(Jensen, 1986). Thus, agency theory answers that there is positive connection between

profitability of firm and its leverage. Moreover, according to this theory, agency costs related

with debt are lesser for firms those having more tangible assets which demonstrate a positive

relationship between asset’s tangibility and leverage of firm. On the other hand, agency theory

reveals that contrary relation between growth opportunities of firm and its level of debt

underlining that the underinvestment issue is more serious for firms those are in growing stage

this leads them to be less leveraged firms (Frank and Goyal, 2005).

Capital Structure Theory

MM with No Corporate Taxes

The first modern theory of capital structure proposed by the financial economist named

“Modigliani and Miller (1958) known as MM model. In this theory they said that without the

corporate taxes there is no possibility for optimal capital structure means that any firm no need

to tangle with the issue of capital structure decision. Since it is assuming that the value of firm

remains unchanged whatever the firm have more or less leverage without considering the

corporate taxes. Modigliani and Miller reveals that in absence of corporate taxes the value of

firm remain same doesn’t matter that the firm is leveraged or all financed with equity. They

conclude that if a firm use more debt financing then its equity become more risky and costly

and the firm going towards the bankruptcy. The theory taking the assumptions that there is no

transaction, agency and distress cost considering all debts are riskless and both companies and

individuals can borrow unlimited amount at risk free rate.

MM with Corporate Taxes

Modigliani and Miller (1963) extend the capital structure theory by incorporating the corporate

tax in it. With this extension they viewed that optimal capital exists. In this regards they explain

that the value of firm increases and its weighted average cost of capital decreases along with

the increase in leverage. In others words as any firms use more debt for financing its value

increase because the firm getting the benefit of tax shield that is due to debt. Thus, the theory

that value of leveraged firm is more than the value of un leveraged firms as leveraged firm get

the benefit of amount equal to present value of the that tax shield acquire on debt. MM with

corporate taxes highlighted that any firm should borrow more and more funds to finance the

operationalization and increase its value and reduce the weighted average cost of capital.

Further, this theory holds that one firm can accomplish an optimal capital structure by using

minimum much higher percentage of debt as associated with equity in order to finance its

operation.

Miller with corporate and personal taxes

Independently Miller (1973) established his theory of capital structure by including the effect

of both corporate and personal taxes. As of MM with corporate taxes, this theory also suggests

the presence of an optimal capital structure for a specific firm. In detail, this theory expects the

firm’s increases as it adds as much as it can debt finance but at a lower rate as associated to

MM with corporate taxes. Additionally, this theory advises that a firm can attain optimal capital

structure by which its value will become extreme holding weighted average cost of capital

lowest. As of MM with corporate taxes, this theory also specified that in direction to attain such

optimal capital structure one firm should use an extreme likely amount of debt as a basis of

finance.

Problem Statement

Our point of concern in this study is to describe the relationship of agency theory and capital

structure and provides information that how the agency problem leads to change in capital

structure and its optimization. And also the costs related to conflicts of interest impact the

capital structure.

Significance

The study is important because it helps to understand the connection of agency theory and

capital structure. Study also help the management for understanding different phenomena

regarding principal agent conflicts of interest and their effect on company value.

Research question

Our discussion of paper is based on the research question which is

Does agency cost affect the capital structure of firm?

Research objective

The objective of this study is to describe and relate the agency theory and capital structure and

provide the better understanding of these and discuss the impact of these agency cost on the

capital structure as well as on the value of the company.

Relationship between agency theory and capital structure

The agency problem happens when the interests of both principal and agent are not remaining

same there is asymmetry of information one party having more information mostly agent

having more information. In the case principal can’t confirm that agents are acting according

to best interest of principal or not. Further sometime agent initiate the actions those are useful

for them but expensive to the principal or ignore the activities that are useful to principal but

expensive for them. Ethical vulnerability and clash of interest may arise. The possibility of

exploitation of principal is more that’s why principal prefer not to enter into transactions from

which both the principal and agent can get benefit. The deviance from the principal's interest

by the agent is called "agency costs". In corporate world the bases on which these clashes arises

are of many kinds and these generate the typical financial problems like policies regarding

dividend payments, decisions regarding investments and capital structure optimization.

Conflicts that impact the capital structure are:

Management and owners’ interest conflict.

Conflict of interest among owners, managers and debtholders.

Capital structure and agency conflicts.

When the manager has portion of firms shares then agency problem occur and this fractional

ownership of firms share effect the work of managers and manager work less heartily as

compare to case of full ownership. And in this case the mangers use more incentives like lavish

offices, luxurious cars, costly hotels etc. because the most of these cost bearing the owners.

The motivation of mangers can be increased by contracting them that they will pay based upon

the value of shares of the company. The theory suggest that this conflict can be settle by using

the debt and involve the debt provider in it but as far as the benefits of debt as also the cost of

debt too.

Benefits of debt to shareholders

The manager should need to control the investment policies as because the regular payment

of rates and interests.

It bound the manger to provide more information and thus asymmetry of information

decreases between the managers and owners.

Associated costs.

The sacrifice of project having the positive NPV because the difference between the present

value and repayment amount is negative.

Moving toward the risky investment projects.

The investigation cost to analyze the nature of debt mangers acquired.

The cost benefits analysis must have done and then use this tool to reduce the conflicts and

maximization of value of firm. Jensen and Meckling in 1976 underlined that an ideal financial

structure brings about from two alterations. (a.) Used of debt because tax is there and financial

expenses are excluded. (b.) Debt invited the cost regarding validation and control,

compensation cost of risky investments to creditors and insolvency cost.

Firms hence take concentration to debt till the point they achieving growth of its value payable

to the bankrolled investments determination equivalent to the marginal costs created by the

debt obligation. Hence the ideal level of debt is that upon which the agency cost is minimum

as both the management and shareholder same view that cost incurred on external financing

must be lesser then investment costs. Which means that debt allow both owners and

management to obey the same objectives. Debt is the tool to encourage the performance of

managers. As the level of debt increases the bankruptcy cost of firm also increases. Bankruptcy

raises the fear of loss of job and other incentives. This threat is very much serious for manager

and enough to make them more energetic. So the manager efficiently manage the operations

and generate the cash flows those are available to compensate the debt and thus this lead the

investment in projects with positive NPV. In the case when no debt taken then bankruptcy risk

are lower and thus the manager do not maximize their performance which ultimately reduces

the value of company. For the owners, the use of debt has leverage effect above the financial

return. Further the use of debt has the benefit of ownership strength as in case of new issue of

equity causes the dilution of ownership. Use of debt causes the conflicts like between the

owners and management once and with debt provider on the other hand and also some cost like

cost of bankruptcy, scrutiny cost and validation cost when owner provide the justification to

the debt provider. Owners and managers can deter their benefits part from assets of company

to harm debt provider. For instance, they make policy to invest in risky projects or can choose

to take debt and part of it distributed as dividends. When the firm having the high ratio of debt

then equity then the owner wanted to invest in the risky projects and enjoy the benefits if the

investment turns profitable. The debt provider known this thus they mention in the agreement

that the manger not invest in risky project during the period of loan.

For the settlement of these agency conflicts among shareholder, manager and debtholder it is

suggested that owner and manager must provide the asset on back of the loans and thus in this

way they avid to invest in the risky projects and they tried to reduce the existing value of loans

thus this ultimately effect the capital structure and lower the value of the company. Despite of

these legal restriction applicable on debts agreements there are other ways through which the

solution can be possible.

Real or insurance assurances sections that conquer the attraction of giving up project with

positive NPV, but lessen the difference of future cash flows in direction to escape a

transmission of wealth to debtors.

In many debt agreements there are sections that limit the freedom of firms to get more

loans. In this section generally the maximum level of debt is connected upon some indicator

of company like its debt to equity ratio, turnover ratio, gross profit margin and liquidity

ratio etc. where these ratios are exceeded then the debt become chargeable.

Dividend payments reduce the level of net assets of the firm and also reduce the guarantee

of debt provider as they provide the loan some time on the back of assets thus sometime in

the loan agreement the clause provided that limit the payment of dividend to owners during

the debt period and also restrict the utilization of reserves and refund of own shares.

Toning of resources and obligations maturity targets the avoidance of de-investment actions

which causing the owners rejection to act in the creditors’ interests, would causes the

decrease of corporation’s value.

Moving on short term debt need frequent renewal and for the project having long term

period the short term debt may causes some problems like it may accumulate more cost

then longer term or may some delay in operation because of frequent renewal and if we

mange short term project it also cause more rentable investments.

Issuance of bond having convertibility option are also use to solve this issue of conflicts of

interest. In this scenario the owners need to change the structure and asset portfolio for

getting the longer term profit although the profit goes to the bond holders who are also the

partial owners but this cause the increase the value of the company rather than the own

interest.

Lease is also available to reduce these agency conflicts in this case the assets substitute

with the investment but lease require more costs. In case of bad maintenance, the more cost

has to bear and maintenance agreement account fall which may be require the flat rate or

may be guarantee deposits etc. generally these type of option finally end on the purchase

of asset.

Agency costs and funding sources

The capital structure determination is not only related with the adjustment of debt and own

investment but also the value the amount of ownership acquired by managers and also other

stockholders therefore three variable considered important for determining the optimal capital

structure.

Fi = Funds internally possessed or under the ownership of managers.

Fe = funds externally possessed or under other stock holders.

D = Debt

Thus Fi+Fe is equal to own possessed funds and can be denoted by F and for determination of

value of company we can use Value = F+D. For determination of rate of externally possessed

funds we can use Fe/D with the assumption that company’s size and external fund amount are

constant.

Through this we can calculate the amount of funds which is optimal for firm that is denoted

OEF (Optimal level of External Funds) from the total funding possessed by external providers.

Thus for this purpose we can use

𝑂𝐸𝐹 =𝐹𝑒

𝐹𝑒 + 𝐷

The current markets are much rational markets the prices of bonds and stocks are mostly

reflects all possible information regarding the company whatever related the costs of control

or transfer cost and also agency cost. Hence the stock or bond of any company much reflected

all these possible situations. Thus when these interest conflicts arises the managing

stockholders are paid to reduce these conflicts. From their part

for a specified level of internally possessed funds, the optimum amount of externally possessed

funds in the total external funding must parallel to an OEF for which the total agency costs,

noted AC (OEF) are least. Figure 1 shows these situations in the better view.

Figure 1

AFe (EF) = Agency cost reliant on EF, related to own external funds

AD (EF) = Agency cost also reliant on EF, related to debts. To be stated that when extreme

(100%) is touched for each of the two externally possessed funds, AD (EF) is lower than AFe

(EF)

AC (EF) = whole Agency costs, equivalent to AFe (EF) + AD (EF).

We will try to understand these meanings, on management behavior associated to agency cost,

existing in the preceding section.

Thus, in place of AFe (EF), when EF = 0 (no externally possessed funds), the manager remains

interested for achieving externally possessed funds. Moreover, this exciting case, any variation

in the worth of the externally possessed funds is equal to the variation of value in the own

possessed funds possessed by the manager; consequently, the agency costs nil. Later, any rise

of EF infers manager’s growth of motivation and for EF=100%, the agency costs will be

highest. This permits the depiction of a curve for total agency cost whose lowest show an

optimal capital structure. If we incorporate the monetary effects of debt (dropping the income

tax sum payable to the deductibility of interest in the purpose of taxable income), we became

a new global representation of debt perimeter.

Figure 2.

1 = Cost of Capital in view of monetary effects.

2 = Cost of capital in view of monetary effects and cost of bankruptcy.

3 = Cost of capital in view of monetary effects, cost of bankruptcy and agency costs.

This graph permits understanding why the corporations do not use debt to the extreme even

though the monetary benefits of debt. If we bring out considering the point that costs of

bankruptcy are as great as the financial leverage (ratio of debt) is upper, the optimization of

financial structure drive to be at point Y. And if we also bring out the costs of agency, which

rise as the level of debt grows, the WACC (weighted average cost of capital) will rise and the

optimal financial structure will be at a lower level on point X.

Conclusions

The agency theory provides the grounds for optimization of capital structure and provide the

grounds for new research. Agency theory initiated with the view that all stakeholders have

different interest and objective that cannot combined in one term thus the deviance of interest

create the conflicts particularly in big corporation where ownership and control spread. While

a corporation practices some outside equity, and there are external owners, the controlling

owners will attempt to make the most of their wealth at the expense of minority stockholders,

with the construction of clashes of interest and the supposed agency cost of equity, which rises

with the percentage of outside equity used by the company. In view of the agency theory, the

structure of the capital fallouts from a conciliation among several funding modes that let the

settlement of conflicts of interests between the capital providers like owners & debt provider

with managers. The capital structure be able to affect the value of the company through

performing on the means of management enthusiasm and provoking the owners and debt

provider to handle the managers and bound their misuses. Empirical evidence of these costs

are also examine by some researchers like Ang et al. (2000) as well as Khan, Kaleem, and

Nazir (2012) established the estimates. Their results have shown that agency costs seem to be

in reverse connected to debt financing. Simple words, more leverage in fact diminishes the

harshness of agency problems. Greater debt ratio means larger creditors’ direction on the firm

performance, or ultimately, on the managers’ actions and choices, which cuts needless costs

and boosts efficiency. Furthermore, interest expenses show a vital part in dropping the available

level of free cash flow and let down the chance that managers would make loss-making

investments.

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