Agency theory and capital structure

Agency theory and capital structure: A descriptive study.
Mirza Muhammad Naseer
MS mgt. CMS 16186
Mirzamnaseer@gmail.com
Idrees Liaqat
MS mgt. CMS 16564
idreesliaqat@gmail.com
Riphah International University, Islamabad.
Abstract
In the world of finance, the agency theory attempts to describe the manners of numerous agents
that mediate in the firm’s funding (managers, stockholders and debt holders) and to evaluate
the influence of these manners on the financial structure. In view of the agency theory, the
optimum 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 fails 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 involve 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 propose 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 assume that the value of firm
remain 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 add 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
Do agency cost theory 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 happen when the interests of both principal and agent are not remain 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 have 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 uses 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 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 bring 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 turn 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 agreement 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 costly
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 needs to change the structure and asset portfolio for
getting the longer term profit although the profit go 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
have 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 situation 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 remain
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 provide 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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