agency theory

Capital Structure/Agency Theory 1
Capital Structure/Agency Theory
Chapter 1: Introduction
The primary objective of any management is to enhance the shareholders’ wealth.
Gitman (2003, p. 56) defines shareholders’ wealth as the price of the outstanding ordinary shares
of a firm. However, some managers might decide to invest in projects that have negative net
present value, resulting into a decline in shareholder’s value. Nonetheless, some scholars suggest
that dividends can be utilized by boards of directors to minimize agency costs. They reduce the
ability of the management to mismanage firm’s resources by investing in projects with low
returns. In fact, paying high dividends significantly decreases the amount of free cash flow in the
organization, which in return reduces agency costs. Apart from paying dividends, firms can also
maximize shareholders’ wealth by implementing logical financial decisions so as to reduce the
cost of capital. A firm’s capital structure can be a combination of debt such as equity and
preference stock. The use of the two debts to raise capital is often regarded as the long-term
financial mix of an enterprise. Therefore, capital structure decisions play an essential role in
maximizing the firm’s returns and enhancing its capacity to conduct operations in a highly
competitive environment.
Organizations’ managers find it extremely difficult to identify the perfect mix of equity
and debt to realize an optimum capital structure that should improve business owners’ returns as
well as reduce the cost of capital. Gitman (2003, p. 75) contends that a firm’s value is maximized
only after the cost of capital is reduced. The author also points out that the optimal cost structure
determines the kind of equity and debt combination that will reduce the cost of capital of a firm
while enhancing its market value and profitability. Thus, capital structure decisions are essential
in determining the profitability and performance of a firm, including equity value.

Chapter 2: Literature Review
2.1 Capital Structure
Capital structure decisions have a significant impact on the cost of capital and value of
the company. According to Firer, Ross, Westerfield, and Jordan (2008, p. 93), ineffective capital
structure decisions might lead to an increase in the cost of money for investment and
consequently decrease the company’s net present value (NPV). Once the new present value of a
project declines, a firm has no option other than abolishing the investment. Therefore, having an
excellent capital structure will reduce the overall costs of the firm and increase the net present
value of projects. The value of a company also increases if it undertakes numerous investments.
Despite the role of capital structure in enhancing the value of businesses, there are no studies that
provide guidelines to practitioners on ways of choosing between equity and debt in their capital
structure. In fact, Firer, Ross, Westerfield, and Jordan (2008, p. 94) argue that the financing mix
(optimal capital structure) does not determine the value of a firm. For this reason, optimal
capital structure is non-existent.
In contrast, Modigliani and Miller (1958, p. 265) contended that a firm’s value greatly
depends on its capital structure under strict conditions of complete, frictionless, and competitive
capital markets. It is often difficult for managers to change the cost or value of capital using the
capital structures that they choose. Equally, financing decisions do not enhance value for
shareholders because they are considered irrelevant. However, scholars with the opposing view
contend that managers can determine the optimal capital structure of a firm (Modigliani & Miller
1958, p. 275). For instance, financial economists have introduced capital markets frictions,
including bankruptcy costs, taxes, and asymmetric information into their models. As such, they
can explain factors that influence capital structure decisions. In addition to the elements, they

have come up with a wide range of capital structure theories, including pecking order and trade-
off theories to help managers to comprehend capital structure implications to a firm.
2.1.1: Trade-Off Theory
The theory points out that capital structure often shifts towards optimal leverage, which is
achieved by balancing the expenses of financial distress and merits of debt. Capital structure
choices are determined by a trade-off between the costs and benefits of a debt (Gitman 2003, p.
95). As illustrated by many researchers, organizations’ optimal capital structure entails the
tradeoff among agency costs and bankruptcy costs, tax benefits, and over-investment that is
linked to asset distribution. It is also assumed by the trade-off hypothesis that a direct
relationship between influence and profitability might increase a firm’s vulnerability to
bankruptcy (Pandey 2009, p. 331). The trade-off theory hypothesis is also confirmed by distinct
studies in various markets. For instance, Pandey (2009) carried out a research that involved
listed information technology firms on the Shanghai Stock Exchange. The outcome of the survey
indicated a positive relationship between performance and capital structure. A similar study
found a connection between debt ratio and profitability. Based on the findings, it is obvious that
firms can utilize more debt to boost their financial performance. Equally, increased debt often
compels company managers to enhance their performance to ensure that their organizations are
not declared bankrupt.
2.1.2: Pecking Order Theory
According to the theory, managers have more knowledge of the activities of companies
compared to investors, a concept that is known as asymmetric information. Because of the
disparity, managers will only issue debt when they are certain about the firm’s future prospects.
Similarly, they will only utilize the equity when they are not certain about the conditions in the

market (Pandey 2009, p. 331). Therefore, a decision to pay principal and fixed interest to debt-
holders indicates that the firm expects continuous flow of cash. Arguably, those who decide to
issue equity clearly indicate that they have over-valued the current share price. Methods that are
used by managers to raise funds signal the confidence that they have in the firm as well as
potential investors.
The actions of business executives suggest that a company will always utilize internal
cash if available and opt for debt if external funding is needed. Pandey (2009, p.331) points out
that there are two categories of equity: internal and external. The former is considered less
expensive and more accessible compared to the latter because individuals are not expected to pay
taxes on retained earnings. Besides, they do not incur transactional costs on the earnings.
However, managers shun disclosing adversarial details about their firms when using internal
finance because some profitable businesses have a lower debt ratio because their internal funds
are adequate to finance their projects. Such companies only issue equity capital if they are sure
that their shares are over-valued.
Furthermore, the pecking order theory assumes that companies start by providing debt,
internal funds, and then equity. According to Myers (1984, p. 586) the target capital structure
does not exist unlike in the trade-off theory. The pecking order theory does not agree with the
idea that companies with a different mix of equity and debt finance reduce their cost of capital.
Therefore, firms that perform well prefer internal financing in contrast to debt. In such cases,
there is a negative correlation between leverage theory and profitability. Other empirical
evidence supports the negative correlation between firms’ performance and capital structure as
well as capital structure and profitability. Equally, other studies indicate that both long-term and

short-term liabilities have a negative correlation with the return on assets.
2.2 Agency Costs
Agency costs are defined as the total monitoring and agent bonding expenditures. As
expenses, monitoring costs are in incurred in controlling, observing, and measuring the behavior
of an agent. They might include writing executive compensation contracts, audits, and the costs
of sacking and hiring top managers (Pandey 2009, p. 332). Bonding theory, on the other hand, is
utilized by the management to enhance the self-interests of shareholders through processes such
as compensating them in case the company collapses. Residual loss emerges from conflict of
interests that emerges from bonding and monitoring measures. Pandey (2009, p. 332) identifies
two categories of agency costs: indirect and direct agency expenses. The former are incurred by
shareholders in order to minimize potential conflicts with company managers as a result of stock
option plans, bonuses, managerial incentives, and audit fees which influence managers’
behaviors. Indirect agency costs arise from the failure by the management to make investments
that contribute to the profitability of the business or mismanagement of internal cash.
Agency costs help firms in mitigating the impacts of agency challenges. Agency
problems are difficulties that financiers encounter while ensuring that their cash is not wasted or
expropriated on projects that are have insignificant impacts on their net worth. Accordingly,
agency costs increase when the interests of firm managers are not in line with those of
shareholders. For instance, preference for making decisions that serve selfish interests reduces
the wealth of the shareholders like on-the-job perks. The amount of the costs is reduced by how
committed managers of a company are. In some institutions like banks, there is a requirement to
monitor outside managers’ actions to ascertain that their behaviors are beneficial to the
businesses.

There is a direct relationship between leverage and agency cost. For instance, high leverage
minimizes the flow of cash for utilization by managers and consequently decreases agency costs
for company owners. Agency costs are also affected in various ways by the use of debt. For
instance, payment of interest to debt holders reduces the amount of cash to spend on investments.
However, a reduction in the flow of cash also aids in curtailing the over-investment that occurs
because managers are venturing into projects with a negative NPV. Equally, the use of debts
helps firms such as banks to monitor their managers to ensure that they are productive.
2.2.1 Conflict Shareholders and Debt Holders
In regards to the assets of the firm, debt-holders have a preferential, but static claim over
them. On the other hand, shareholders have a residual, but unrestricted claim over the assets of
the firm. Equally, they have restricted liability when meeting the obligations of the company. In
times of financial crises, shareholders can decide to invest in other businesses that have the
potential to perform better. In contrast, debt-holders in a highly leveraged firm have higher risk
because shareholders exhibit limited liability. They are not compensated by the business in case
of a debt default, resulting into the transfer of their wealth to shareholders (Pandey 2009, p. 333).
The conflict between debt-holders and shareholders, therefore, emerge because of the likelihood
of former’s wealth being transferred in favor of the latter. The conflict also arises when firms
invest in low risk projects, which have minimal effects on the wealth of shareholders. Besides,
businesses can accumulate more debt that is more risky, subjecting debt-holders to a threat of
loss of wealth.
2.2:2 Conflict Between Managers and Shareholders
The legal owners of a firm are shareholders, and it is the role of the management to
ensure that their interests are satisfied. However, conflict between managers and shareholders

emerge because of two main reasons. Firstly, managers might use the wealth of shareholders to
fulfill their selfish interests by increasing their perquisites and compensation. Secondly, they can
focus on safeguarding their jobs rather than ensuring that the needs of shareholders are met.
Equally, some business executives reject profitable investments because of the level of risks that
they are associated with. As a result of the conflict, a shareholder democracy movement has been
developed with the aim of increasing the influence of company owners in the decision making
processes of companies (Nieuwenhuizen & Machado 2004, p. 43). Advocates of increased
engagement of shareholders in corporate activities contend that it is important for owners of
firms to be given all the powers to make decisions since conflict of interest is caused by the
choices that are made by the management. With more authority, shareholders can delegate some
tasks to experts and make decisions that contribute to the growth of their businesses.
Those with a contradictory view posit that shareholders lack sufficient skills and
knowledge to make decisions that are valuable to organizations. The same critics point out that
some shareholders’ ultimate goal is not to enhance the interest of the firm but to fulfil individual
desires. For instance, they might decide to utilize their authority to champion an environmental,
social, or political agenda without thinking about the impact on profitability. Equally, some
might decide to increase the stock price of the firm using temporal measures, which eventually
reduces the value of the company (Pandey 2009, p. 334; Baker & Powel 2010, p. 63).
The urgency challenges that emerge as a result of the conflicts between managers, debt-
holders, and shareholders can be addressed through restrictive and monitoring covenants.
External investors comprehend that managers might not be committed to fulfilling business
interests. For instance, they have a tendency to discount prices of securities when the outcome is
favorable to them (Firer, Ross, Westerfield, & Jordan 2008, p. 32). In order to safeguard their

interests, external investors often require firms to put in place restrictive and monitoring
covenants. Debt-holders, on the other hand, put limitations on the amount of cash that a firm can
borrow. Equally, they take into consideration experts’ opinion while evaluating an organization’s
performance and prospects for future expansion. Likewise, shareholders design numerous
monitoring mechanisms to ensure that managers invest and borrow funds in order to realize
wealth maximization goals.
2.3: Financial Leverage and Financial Performance
Financial leverage determines the extent to which companies utilize debt and equity to
acquire more assets. A higher leverage ratio illustrates the degree to which a firm depends on
debt financing. In fact, a majority of corporations utilize equity and debt to finance their
investments; however, they can also utilize preference capital. The only limitation is that interest
rates on debt are fixed regardless of the rate of return on the investments. The financial leverage
approach that is adopted by a firm should aim to increase earnings on the fixed charges. In a
study by Pandey (2009) to assess the correlation between financial performance and financial
leverage in the Pakistan energy and fuel sector, it was concluded that a direct relationship existed
between firms’ performance and financial leverage. The productivity of a business is a great
concern to debt-holders and shareholders. The latter own the firm, and are greatly impacted by
risks in the company because of their residual claim on assets. However, businesses only reward
them through dividend payment and increasing their share equity value. Debt-holders, on the
other hand, are rewarded via interest payments. They regard the assets of the company as
collateral, which they can reclaim in case the company defaults in payment.
In perfect markets, the firm’s value is not affected in any way by the capital structure.
However, organizations can increase their value by transforming the capital structure owing to

the tax benefits that are associated with debt payments. Equally, free-cash-flow and agency cost
theories assert that capital structure determines the performance of the business. Based on the
tenets of the theories, a firm gains from utilizing debts to finance activities because no tax is
charged on the interest that is paid. As such, it is easy to increase the value of the firm using
debts (Myers 1984, p.583). However, stockholders often attempt to acquire a debt to ensure that
managers are committed to the available fixed payments. Banks also utilize financial tools such
as debt-to-assets ratios to ensure that the management focuses on adhering to specific conditions
and consequently improve the efficiency of the firm. Additionally, business leaders are expected
to make public the debt holders’ income generating activities to prevent conflict of interest.
However, conflict of interest also arises between the owners of the firm and the management
when the latter decides to fund meaningless projects, resulting into reduced performance.
Besides, the agency costs theory argues that an increase in financial leverage leads to a
decline in debt expenses. Improved firm performance is linked to low indebtedness, which is
realized if a business focuses on shunning bankruptcies or avoiding restrictions for investments.
Stockholders can as well utilize dividends to minimize the flow of cash to the management. Time
lags also affect the impact of financial leverage on financial performance as explained by the
pecking order theory. Even though various studies have examined the connection between firm
performance and financial leverage for distinct countries, there is no consensus among
academicians on the variables’ impact on organizations’ performance (Baker & Powel 2010, p.
34).
2.4: Effects of Leverage on Profitability
Leverage helps firms and investors to venture into better markets, but it is associated with
the greatest risk. Leveraging investments can increase both losses and gains. However,

companies can utilize it in an attempt to increase shareholders’ wealth. Firms that have high
fixed costs after break-even record an increase in operating cash following a rise in output.
Those with low variable costs experience a slight increase in operating income after an increase
in output owing to the fact that costs affect the level of output. Nieuwenhuizen and Machado
(2004, p. 85) also note that financial leverage is connected to the utilization of borrowed capital
and cost in a firm. If a company’s profitability is higher than the rate of interest on the borrowed
capital, then utilization of the capital results into increased performance. Thus, a firm utilizes
borrowed capital with the hope that it will lead to a rise in earnings. However, if the borrowed
capital’s interest rate is higher than the firm’s profitability, the business owners’ wealth declines,
resulting into reduced company performance. Therefore, it is imperative that organizations put
into consideration various factors, including the link between internal and external sources of
capital when determining ways to improve profitability. They should as well comprehend the
cost of capital and the level of returns on investment since profitability is calculated as the return
on the total assets of the company.
As per the pecking order theory, companies that are highly profitable minimize the use of
external funding. As such, they show creditors that their bankruptcy risk is very low. In some
instances, highly profitable firms can use debt at interest rates that are very low since creditors
consider them stable. Moreover, well performing organizations generate more revenues
compared to less profitable businesses. Consequently, they have a tendency to reduce
information asymmetry to interested users, investors, and creditors through the participation of
multiple parties in decision making processes. Therefore, there is a direct link between
profitability and leverage.
2.5: Free Cash Flow and Agency Costs

A common disagreement between managers and shareholders due to the separation of
agency costs, control, and proprietorship that is caused by the latter’s inability to monitor the
former are well explained in various literatures. According to the agency costs of free cash flow
hypothesis, the inability of shareholders to effectively monitor managers’ opportunistic behavior
increases the likelihood of spending cash that was generated internally to fulfill their own selfish
interests rather than maximizing the value of the firm (Nieuwenhuizen & Machado 2004, p. 43).
Based on the tenets of the theory, free cash flow leads to extreme agency problems. Jensen
(1986, p. 323) considers free cash flow as the primary variable in determining the level of
urgency costs. Therefore, controlling the level of agency costs requires firms to utilize financial
leverage and dividend policies that have a direct impact on the free flow of cash in the business.
Besides, free cash flow is utilized as a criterion for analyzing firms’ financial health and
performance. It has important and useful applications for managers and shareholders. For
instance, individuals in companies with free cash flow can invest it in a wide range of
opportunities. However, some managers might invest in projects that are characterized by lower
yield compared to the cost of capital or those that are extremely risky. For this reason, agency
theory points out that, managers might channel their focus on fulfilling their own goals that
contradict those of the shareholders. For instance, some might utilize the free cash flow in
wasteful practices despite increased investor protection. Jensen (1986, p. 323) argues that the
existence of free cash flow policies in an organization signify the risk of managers’ excessive
investments.
The free cash flow theory points out that excess internal cash compels managers to shun
market controlling. In such instances, they do not require permission from shareholders when
making decisions on the projects to invest in. Thus, the managers are highly motivated to spend

funds to a wide range of activities even when projects with positive net present value do not exist
in the market. With availability of internal cash, managers assume the powers of discernment and
judgment on the investment decisions to be made by the firm as well as increase their control
over unrestrained resources. Accordingly, Nieuwenhuizen and Machado (2004, p. 64) allege that
firms that have excess internal funds have a tendency of spending more on capital expenditures
and acquisitions despite the fact that they are associated with less valuable investment
opportunities. The authors also note that an increase in free cash flow mostly leads to investment
in projects whose net present value is negative instead of using the money to pay shareholders as
dividends. Thus, urgency problems are prevalent among companies with a high level of free cash
flow. Additionally, firms with reduced growth opportunities and increased free cash flows pay
high audit fees, an indicator that the auditors have acknowledged the agency issues that are
associated with the companies’ operations.
2.6: Dividends in Reducing Agency Costs
The agency theory assumes that increased retention of earnings makes most managers to
reduce investments that increase the value of shareholders. For this reason, dividends can be
utilized as a crucial financial tool in eliminating capital/asset structure that encourages managers
to invest in invaluable projects. The use of dividends is logical taking into consideration the
principles of the agency theory. In most cases, managers gain control over the resources that are
owned by corporations as a result of external contributions of equity capital or debt as well as
earning retentions. The importance of contributed capital is that businesses implement
monitoring mechanisms since suppliers understand that the policies of some managers can favor
low evaluations. As mentioned previously, firms with increase free cash flow have a tendency of
funding projects that reduce the wealth of stakeholders. However, the behavior can be controlled

by continuous allocation of cash to shareholders to minimize the financial resources that are used
by the management. In fact, regular payment of dividends decreases agency problems and threats
to an organization. Equally, the correlation between paying dividends and earned equity is
economically and statistically significant.
Determinants of Model
The research analyzes the determinants of firms’ performance in the context of capital
structure. Some of the elements that promote companies’ productivity include the use of equity
or debt by to finance activities. Other determinants entail return on equity and assets, the size of
the firm, earnings per share, as well as short term and long term debt to capital ratio.
Data
Historical and actual information will be collected from approximately ten firms that
have been listed on the United Kingdom Stock Exchange between 2013 and 2016 utilizing the
document analysis method. Financial statements of the identified companies and National Stock
Exchange Website will also be analyzed to gather essential data. Equally, secondary data sources
will be useful in gathering in-depth analysis of the topic. The companies will be randomly
selected to eliminate systematic bias, and the collected data will help in finding out if a
relationship exists between the firms’ performance and capital structure
Methodology
The study will be based on the correlation between the performance of a firm and its debt
accumulation. Therefore, the researcher will utilize the deduction method and qualitative
techniques to analyze and collect data respectively from secondary sources.
Results

From the literature review, an increase in a firm’s long-term debt and total debt is linked
to a decline in profitability. The decrease is attributed to the fact that debts are relatively
expensive compared to equity. Therefore, borrowing to fund an expansion of business activities
results into lower profitability. The results also indicate a negative link between profitability and
total debt as measured by earnings per share, return on assets, and return on equity. The
association suggest that profitability declines or increases depending on the company’s debt
position.
Conclusion
Firms’ performance greatly depends on how managers utilize free-cash-flows in the
organization to fund projects. Some individuals use the resources to increase shareholders’ value
by investing in projects with positive net present value. However, others invest in projects with
negative present value, resulting into an organization’s decline in profitability due to an increase
in agency costs. Investing in projects with low returns also contributes to the conflict between
shareholders and managers. Thus, the latter are often advised to use dividends as a means of
reducing agency problems in the organization. Additionally, conflict of interest can be prevented
by mandating firms to put in place restrictive and monitoring measures as well as putting
limitations on the amount of cash that a firm can borrow. Another essential activity is evaluating
an organization’s performance and prospects for future expansion. Firms can utilize their
financial leverage to boost shareholders’ wealth without increasing the amount of debt. As such,
managers can help firms and investors to venture into better markets in an attempt to increase
value for shareholders. This concept is supported by the agency costs theory, which posits that an
increase in financial leverage leads to a decline in debt expenses and consequently improved firm
performance.

References
Baker, H. K. & Powel, R., 2010. Corporate governance: A synthesis of theory, research and
practice. Hoboken, NJ: John Wiley and Sons.
Firer, C., Ross, S. A., Westerfield, R.W., & Jordan, B. D., 2008. Fundamentals of corporate
finance (4th ed.). Berkshire: McGraw Hill.
Gitman, L.J., 2003. Principles of managerial finance. Boston: Addison Wesley/Pearsons
education.
Jensen, M. C., 1986. Agency costs of free cash flow, corporate finance, and takeovers. American
Economic Review, 76, pp. 323-339.
Modigliani, F., & Miller, M., 1958. The cost of capital, corporation finance and the theory of
investment. The American Economic Review, 48(3), pp. 261-297.
Myers, S. C., 1984. The capital structure puzzle. The Journal of Finance, 39(3), pp.575‐589.
Nieuwenhuizen, C., & Machado, R., 2004. Basics of Entrepreneurship. Lansdowne: Juta
Academic.
Pandey, I. M., 2009. Financial management. New Delhi: Vikas Publishing House.

Appendix
Capital Structure Theory Summary
Theory Causality Relationship
Modigliani and Miller Performance of the firm
affects debt
There is a positive
relationship between firm’s
performance and debt
Agency theory Debt affects firms
performance
There is a negative
association between
Free cash flow theory Firm’s performance is
affected by debt
There is a positive
connection between
Pecking-Order theory The performance of a firm
affects debt
Negative
Trade-Off theory The performance of the firm
affects debt
positive

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