A SUMMARY OF THEORY OF FIRM: MANAGERIAL BEHAVIOR, AGENCY COSTS AND OWNERSHIP STRUCTURE BY JENSEN, MICHAEL C., AND WILLIAM MECKLING (1976)

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JANUARY 2021
BUSARI RASHEED AJIBOLA
A SUMMARY OF THEORY OF FIRM:
MANAGERIAL BEHAVIOR, AGENCY
COSTS AND OWNERSHIP STRUCTURE
BY JENSEN, MICHAEL C., AND WILLIAM
MECKLING (1976)

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ABSTRACT
This paper integrates elements from the theory of agency, the theory of property
rights and the theory offinance to developa theory of the ownershipstructure of the
firm. We define the concept of agencycosts, 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 oftheir existence. We alsoprovide 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.
1.0 INTRODUCTION
1.1 MOTIVATION OF THE PAPER
The paper uses the following below to develop theory of owner structure of a firm
 Theory of property rights
 Theory of agency
 Theory of finance
The relationship between these three theories tries to further define what a firm is
in the following aspect
 Separation of ownership and control
 why an entrepreneur or manager in a firm which has a mixed financial structure (containing both debt and
outside equity claims) will choose a set of activities for the firm such that the total value of the firm is less
than it would be if he were the sole owner
 why his failure to maximize the value of the firm is perfectly consistent with efficiency
 why the sale of common stockis a viable source of capital even though managersdo not literally maximize
the value of the firm
 Why debt was relied upon as a source of capital before debt financing offered any tax advantage relative
to equity
 Why preferred stock would be issued

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 Why accounting reports would be provided voluntarily to creditors and stockholders, and why
independent auditors would be engaged by management to testify to the accuracy and correctness of such
reports
 Why lenders often place restrictions on the activities of firms to whom they lend, and why firms would
themselves be led to suggest the imposition of such restrictions
 Why some industries are characterized by owner-operated firms whose sole outside source of capital is
borrowing
 Why highly regulated industries such as public utilities or banks will have higher debt equity ratios for
equivalent levels of risk than the average non-regulated firm
 Why security analysis can be socially productive even if it does not increase portfolio returns to investors.
1.2 THEORY OF THE FIRM: AN EMPTY BOX?
The firm is a “black box” operated so as to meet the relevant marginal conditions
with respectto inputs and outputs, thereby maximizing profits, or more accurately,
present value. So many scholars have tried to explain theory of firm in terms of
profit orvalue maximization, but none has tried to explain how conflicting objectives
of participants in a firm has brought about the profit or value maximization.
1.3 PROPERTY RIGHTS
The focus of the paper tries to explain how specificationofrights (costand rewards)
in relation to performance of duties as specified in a contract affect the individual
behavior and manager behavior in a firm (owners and managers of the firm)
AGENCY COST
This literature defines anagencyrelationshipas a contractunderwhich one ormore
persons (the principal(s)) engage anotherperson(the agent)to performsome service
on their behalf which involves delegating some decision making authority to the
agent. The level of utility maximization of both the principal and the agent
determines the success of the relationship because both parties will always have
divergence view about the objectives of the firm. We can say that relationship

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betweenshareholders andmanagers ofa corporationis anagencyrelationship. This
type of relationship has led to agency problem for corporations. The following are
the agency problem associated with agency relationship
 Separation of ownership and control
 The problem of inducing an agent to behave as if he were maximizing the principal’s welfare
In trying to ensure both parties maximize their utility, each part must spend some
cost to ensure non-divergence of the firm objectives. Such cost is known as agency
cost (sum of monitoring cost, bonding cost, and residual loss)
Agency cost can be categorized into three
 Monitoring cost: this is the expenditure by the principal to ensure that the agent did not divert from the
objectives of the firm
 Bonding cost: this is the cost promised by the agent to spend incase he divert from the firm’s objectives.
 Residual loss: is the dollar equivalent of the reduction in welfare experienced by the principal as a result
of divergence of the agent from the firm’s objectives
Thus, this paper tries to explain the analysis of agency cost generated by the
contractualarrangements betweenthe owners andtop managementofcorporations
in a way to provide appropriate incentives for the agent to make choices which will
maximize the principal welfare given that uncertainty and imperfect monitoring
exist.
1.5 GENERAL COMMENTS ON THE DEFINITION OF THE FIRM
Ronald Coase(1937)defines firm as that range of exchanges overwhichthe market
system was suppressed andwhere resource allocationwas accomplishedinsteadby
authority and direction while Alchian and Demsetz (1972)object to the notion that
activities within the firm are governed by authority, and correctly emphasize the
role of contracts as a vehicle forvoluntary exchange. Thus, contractualrelations are
the essence of the firm, not only with employees but with suppliers, customers,
creditors and so on. We can say that firms are legal fiction which serve as a nexus
for a set of contracting relationships among individuals and which is also

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characterized by the existence of divisible residual claims on the assets and cash
flows of the organizationwhich can be generallysolwithout permission of the other
contracting individuals.
1.6 OVERVIEW OF THE PAPER
We develop our theory in stages. Sections 2 and 4 provide analyses of the agency
costs ofequityanddebt, respectively. These formthe majorfoundationofthe theory.
In Section 3, we pose some questions regarding the existence of the corporate form
of organization and examines the role of limited liability. Section 5 provides a
synthesis of the basic concepts derived in sections 2-4 into a theory of the corporate
ownership structure which takes account of the trade-offs available to the
entrepreneur-manager between inside and outside equity and debt. Some
qualifications and extensions of the analysis are discussedin section6, and section7
contains a brief summary and conclusions.
2.0 THE AGENCY COSTS OF OUTSIDE EQUITY
2.1 OVERVIEW
This explains the effect of shareholding structure on the agency cost and how both
the principal and agent will maximize utility if the firm is 100%wholly owned and
otherwise. If a wholly owned firm is managed by the owner, he will make decisions
that maximize his utility (pecuniary and non-pecuniary benefits). The optimal mix
(in the absence of taxes) of the various pecuniary and non-pecuniary benefits is
achievedwhenthe marginalutility derived from an additional dollarof expenditure
is equal to each non-pecuniary item and equal to the marginal utility from an
additional dollar of after-tax purchasing power (wealth).
If the owner-manager sells equity claims on the corporation which are identical to
his own (i.e., which share proportionately in the profits of the firm and have limited
liability), agencycosts will be generatedby the divergence betweenhis interest and

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those of the outside shareholders, since he will then bear only a fraction of the costs
of any non-pecuniary benefits he takes out in maximizing his own utility. As the
owner-manager’s fraction of the equity falls, his fractional claim on the outcomes
falls and this will tend to encourage him to appropriate larger amounts of the
corporate resources in the form of perquisites. This also makes it desirable for the
minority shareholders to expend more resources in monitoring his behavior. Thus,
the wealth costs to the ownerof obtaining additional cashin the equity markets rise
as his fractional ownership falls.
2.2 A SIMPLE FORMAL ANALYSIS OF THE SOURCES OF AGENCY
COSTS OF EQUITY AND WHO BEARS THEM
In order to analyze the sources of agency cost of equity, two set of assumptions are
made categorized into: permanent and temporary assumption
PERMANENT ASSUMPTION
 P.1 All taxes are zero
 P.2 No trade credit is available
 P.3 All outside equity shares are non-voting
 P.4 No outside complex financial claims, such as convertible bonds or warrants can be issued
 P.5 No outside owner gains utility other than through the wealth and the cash flow
 P.6 All dynamic aspect of the multiperiod nature of the problem are ignored
 P.7 The manager’s wage are held constant throughout the analysis
 P.8 There exist a single manager with ownership interest in the firm
TEMPORARY ASSUMPTIONS
 T.1 The size of the firm is fixed
 T.2 No monitoring or bonding activities are possible
 T.3 No debt financing through bond, preferred stock, or personal borrowing is possible
 T.4 All element of the manager’s decision problem included by the presence of uncertainty and the
existence of diversifiable risk are ignored

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Define

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FIG 1
V: value of the firm
F: manager’s expenditures on non-pecuniary benefit
U: indifference curve of the manager
VF: budget constraint
α: fraction of manager’s equity
D: when the owner has 100% equity
A: If the owner-manageris free to choose the level of perquisites, his welfare will be
maximized by increasing his consumption of non-pecuniary benefits
B: If the owner has decided to sell a claim 1-α of the firm, his welfare will be
maximized
V1-V2 (P1-P2);is the residual loss. Tradeoffthe owner-managerfaces betweennon-
pecuniary benefits and his wealth after the sale
Owner-manager and investors:
 When the owner-manager sells (1-α): investors will pay (1-α) V* if they did not know the manager
consumes perks of F0 and the real firm value is V0 now. The manager moves along V1P1 (slope = - α)
and he gets up to a higher indifference curve with equilibrium point A.

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 If the investor expects the owner manager’s consumption of perks, the manager could only move along
the true budget line (V-barF),so B is the equilibrium point. V2P2 represents the tradeoff between the firm
value and manager’s non-pecuniary benefits after selling (1-α).
THEOREM
For a claim on the firm of (1- α) the outsider will pay only (1- α) V when he expects
the firm to have given the induced change in the behavior of the owner- manager.
W = S0 + Si = S0 + V (F, )
= S0 +V’ = (1-)V’ + V’
= V’
DETERMINATION OF THE OPTIMAL SCALE OF THE FIRM
FIG 2

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The expansion path OZBC represents the equilibrium combinations of wealth and
nonpecuniary benefits, F, whichthe managercouldobtainif he had enoughpersonal
wealth to finance all levels of investment up to I*. It is the locus of points such as Z
and C which presentthe equilibrium position for the 100 percentowner-managerat
eachpossible levelof investment, I. If the managerobtained outside financing and if
there were zero costs to the agency relationship (perhaps because monitoring costs
were zero), the expansionpath would also be representedby OZBC. Therefore, this
path represents what we might call the “idealized” solutions, that is, those which
would occur in the absence of agency costs.
The distance A measures the gross agency cost while Point C denotes optimum
investment, I*, and non-pecuniary benefits, F*, when investment is 100% financed
by entrepreneur. Point D denotes optimum investment, I’, and non-pecuniary
benefits, F, when outside equity financing is used to help finance the investment and
the entrepreneur owns a fraction α of the firm.
The expansion path ZEDHL represents his complete opportunity set for
combinations of wealth and nonpecuniary benefits, given the existence of the costs
of the agency relationship with the outside equity holders.
2.4 THE ROLE OF MONITORING AND BONDING ACTIVITIES IN
REDUCING AGENCY COSTS
In practice, it is usually possible by expending resources to alterthe opportunity the
owner-manager has for capturing non-pecuniary benefits. These methods include
auditing, formal controlsystems, budget restrictions, the establishment of incentive
compensation systems which serve to identify the manager’s interests more closely
with those of the outside equity holders, and so forth.

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FIG 3
Figs. 1 and 3 are identicalexceptfor the curve BCE in fig. 3 which depicts a “budget
constraint” derived when monitoring possibilities are taken into account.
M: the optimal monitoring expenditure of the outside ( for this case: distance
between C & D)
BCE: the opportunity set as the tradeoff constraint facing the owner
V = V – F(M, α) – M
If the equity market is competitive and makes unbiased estimates of the effects of
the monitoring expenditures onF and V, potentialbuyers willbe indifferent between
the following two contracts:

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 Purchase of a share (1-α) of the firm at a total price of (1-α)V’ and no rights to monitor or control the
managers consumption of perquisites
 Purchase of a share (1-α) of the firm at a total price of (1-α)V’ and the right to expend resources up to an
amount equal to D-C which will limit the owner-manager’s consumption of perquisites to F
2.5 PARETO OPTIMALITY AND AGENCY COSTS IN MANAGER
OPERATED FIRMS
FIG 4
The existence and size of the agency costs depends on the nature of the monitoring
costs, the tastes of managers for non-pecuniary benefits and the supply of potential
managers who are capable of financing the entire venture out of their personal
wealth
2.6 FACTORS AFFECTING THE SIZE OF THE DIVERGENCE FROM
IDEAL MAXIMIZATION
The magnitude of agency cost in relation to utility maximization for both the
principal and agent varies among firms because of the following:
 Size of the firms
 Geographical location and operating activities
 Attractiveness of the pecuniary and non-pecuniary benefits
 Existence of competition in product and factor market do constraint the behavior of managers to idealized
value maximization

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 Capital market in relation to ease at which principal can sell its corporations if he finds out that future
earnings will be higher than the present value earnings from the agency relationship
 Costs of monitoring and bonding activities
 Cost of measuring managers (agent) performance and measuring against the industry benchmark
 Taste of managers in relation to ease at which they can exercise their own preferences as opposed to value
maximization in decision making
4.0 THE AGENCY COST OF DEBT
The agency cost of debt explains why manager tries as much as possible to make
sure that the source ofcapitalfora corporationis financedsolelybyequity or wholly
owned and avoid diffuse ownership structure type of finance.
The following are the reason why large corporations don’t observe individually
owned with a tiny fraction of the capital supplied by the entrepreneur in return for
100 percent of the equity and the rest simply borrowed
 The incentive effects associated with highly leveraged firms
 The monitoring costs these incentives effects engender
 Bankruptcy and reorganization costs
4.1 THE INCENTIVE EFFECTS ASSOCIATED WITH DEBT
 The opportunity wealth loss caused by the impact of the debt on the investment decision of the firm
 Bankruptcy behavior is the willingness of the residual claimant to engage in extremely high risk projects
when there is no equity at stake.
 Under-investment is often find that new investment helps the bondholders at the stockholders’ expense
 Strong incentive to engage in activities (investments) which promise very high payoffs if successfuleven
if they have a very low probability of success.
 Issuance of debt generates agency costs, which are the responsibility of the owner-manager
4.2 THE ROLE OF MONITORING AND BONDING COSTS
 To limit the managerial behavior which results in reductions in the value of the bonds for the bondholders
 Manager is likely to incur bonding costs to reduce effects of internal and external monitoring costs
4.3 BANKRUPTCY AND REORGANIZATION COSTS
 Operating costs and revenues of a firm are adversely affected

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In summary, the agency costs associated with debt consist of:
 The opportunity wealth loss caused by the impact of debt on the investment decisions of the firm
 The monitoring and bonding expenditures by the bondholders and the owner-manager (the firm)
 The bankruptcy and reorganization costs
4.4 WHY ARE THE AGENCY COST OF DEBT INCURRED?
The owner-manager bears the entire wealth effects of the agency costs of debt and
he captures the gains from reducing them. Thus, the agency costs associated with
debt discussed above will tend, in the absence of other mitigating factors, to
discourage the use of corporate debt. The following are the factors that encourage
the use of debt:
 Tax subsidy on interest payments
 Opportunity cost in usage of debt for profitable investment opportunities
5.0 A THEORY OF THE CORPORATE OWNERSHIP STRUCTURE
This theory explains the integration of outside claim (debt and equity) on the
ownership structure of a firm. It makes use of the ownership structure because it
considers the fractionof equity held by managers ratherthan the relative amount of
debt and equity. Thus for a given firm the theory determines three variables:
5.1 DETERMINATION OF THE OPTIMAL RATIO OF OUTSIDE EQUITY
TO DEBT

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FIG 5
Fig. 5 presents a breakdown of the agency costs into two separate components:
Define ASo(E) as the total agency costs (a function of E) associated with the
‘exploitation’ of the outside equity holders by the owner-manager, andAB(E) as the
total agency costs associated with the presence of debt in the ownership structure.
At(E) = ASo(E) + AB(E) is the total agency cost.
(1)As long as capital markets are efficient the prices of assets such as debt and
outside equity will reflect unbiased estimates of the monitoring costs and
redistributions which the agency relationship will engender
(2)The selling owner-manager will bear these agency costs

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Thus, from the owner-manager’s standpointthe optimal proportion ofoutside funds
to be obtained from equity (versus debt) for a given level of internal equity is that E
which results in minimum total agency costs.
5.2 EFFECTS OF THE SCALE OF OUTSIDE FINANCING
FIG 6
Fig. 6 presents a plot of the agency cost functions ASo(E), AB(E) and At(E) =
ASo(E)+AB(E), for two different levels of outside financing. Define an index of the
amount of outside financing to be
K = (B + So)/V*,
and considertwo different possible levels ofoutside financing Ko and K1 for a given
scale of the firm such that Ko < K1.