THE IMPACT OF AGENCY THEORY ON CAPITAL STRUCTURE: A DESCRIPTIVE STUDY

1. THE IMPACT OF AGENCY THEORY ON CAPITAL STRUCTURE: A DESCRIPTIVE
STUDY
ABSTRACT
This paper aims to provide descriptive study on how agency relationship and ownership structure
influences financing decision making as it relates to the capital structure of a firm.
INTRODUCTION
Jensen and meckling (1976) uses agent/principal relationship in relation to agency cost to
determine decision making as it relates to ownership structure of a firm. He proposes that the level
of utility in relation to financing, investment and operating decision making is dependent on the
ownership structure of the firm. In owner manger wholly owned structure situation, such manager
will want to make decision to satisfy his utility first at the detriment of the overall objectives the
firm since he is representing both the agent and principal while in a diffuse owned structure,
satisfaction of utility and execution of responsibilities by the manager is dependent on the contract
terms and benefits (pecuniary and non-pecuniary benefits) . Ang et al. (2000), and Fleming et al.
(2005), shows that agency costs generated from the conflicts between outside equity holders and
owner-manager could be reduced by increasing the owner-managers’ proportion in equity, i.e.,
agency costs vary inversely with the manager’s ownership. Capital structure (leverage) for the
firms is determined by agency costs, i.e., costs related to conflict of interests between various
groups including managers, which have claims on the firm’s resources (Harris and Raviv, 1991).
Hence, execution of the firm’s objectives in an owner’s manager wholly owned structure differs
from diffused equity ownership and debt ownership structure. This execution of firm’s objectives
necessitated the creation of agency cost used in monitoring how the manager’s (agent) interests
will not be in divergence from the owners (principal) interests. Jensen (1976) opines both the
principal (monitoring cost) and agent (bonding cost) expend agency cost as it relates execution of
the firm objectives while the principal (firm) bear the residual loss cost for divergence of the firm’s
objectives by the agent.

2. The main purpose of this paper is to provide some descriptive evidence on the impact of agency
theory on capital structure. We shall focus on two questions:
 Does agency relationship have impact on capital structure decision making?
 Who makes optimal decision as regards cost of debt and cost of equity in capital mix
decision making?
Jensen (1976) identified two major problems that arises from agency relationship: separation of
ownership and control, inducement of agents to carry on business activities as if he is pursuing
firms’ objectives. The separation of ownership and control led to who makes critical decision as
regards the capital mix of the firm. Decision making as regards Capital structure of a firm is
dependent on the ownership structure and the policy of the firm. The optimal performance of an
agent as regards cost of equity decision making is not the same as cost debt. In an equity or owner
manager ownership structure, the principal monitoring cost is lower compare to mix of equity and
debt ownership structure because if the agent is given free hand to make decision in an equity/debt
ownership structure, such manager will want to increase the debt structure of the firm because the
cost of debt is lower and easier than cost of equity , however, when debt rises to a certain stage, it
will threaten the continue existence of the firm which might lead to bankruptcy and reorganization.
According to M&M (1958), he opines that capital mix of a firm is irrelevant to the valuation of a
firm and what is important is the cashflow from the operating activities of the firm while
Durand(1952) believes increase in debt ratio increases the capital structure which in turn makes
the firm to achieve lower cost of capital.
Equity holders have a residual claim on cash flows. What they care about are profits and earnings
from the projects they invest on. They may accept any projects which will increase firm’s value
no matter how risky they are. However, debt holders do not only share profits and earnings with
equity holders, but also have a fixed claim on cash flows, which is the interest of debt. Therefore,
what they focus on is the security of their claims. This conflict between equity holders and debt
holders may affect a firm’s decisions on three dimensions: investment, financing strategy and
dividend distribution.

3. REFERENCES
Ang, J.S.; R.A. Cole and Lin, J.W., (2000). Agency costs and ownership structure, Journal of
Finance, 5, pp81-106
Fleming, G., Heaney, R,. and McCosker, R. (2005). Agency costs and ownership structure in
Australia, Pacific-Basin Finance Journal, 13, pp29-52.
Jensen, M. and Meckling, W. (1976). A Summary Of Theory Of Firm: Managerial Behavior, Agency
Costs And Ownership Structure