Theory of the firm: Managerial Behaviour, Agency Costs and Ownership Structure’ Journal of Financial Economics, written by Jensen, M. And Meckling, W. edited by Anacominfo Journal

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This research work integrates elements from the theory of agency, the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm agency costs, 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 of their existence. It provide a new definition of the firm, and show how 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.
The agency relationship as a contract under which 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. There is good reason to believe that the agent will not always act in the best interests of the principal. The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent. In some situations it will pay the agent to expend resources (bonding costs) to guarantee that he will not take certain actions which would harm the principal or to ensure that the principal will be compensated if he does take such actions. It is  impossible for the principal or the agent at zero cost to ensure that the agent will make optimal decisions from the principal’s viewpoint. In most agency relationships the principal and the agent will incur positive monitoring and bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal. The dollar equivalent of the reduction in welfare experienced by the principal as a result of this divergence is also a cost of the agency relationship, and we refer to this latter cost as the “residual loss. The growth in the use of the corporate firm as well as the growth in market value of established corporations suggests that at least, up to the present, creditors and investors have by and large not been disappointed with the results, despite the agency costs inherent in the corporate form. Agencycosts as the sum of:  The objective of this paper is to help explain the following: 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 and why this result is independent of whether the firm operates in monopolistic or competitive product or factor markets;  why his failure to maximize the value of the firm is perfectly consistent with efficiency;  why the sale of common stock is a viable source of capital even though managers do 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; 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 debtequity 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.
 Sections 2 and 4 provide analyses of the agency costs of equity and debt respectively. These form the major foundation of the 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 discussed in section 6. Concluding that agency costs are non-zero (i.e., that there are costs associatedwith the separation of ownership and control in the corporation) and concluding therefrom that the agency relationship is non-optimal, wasteful or inefficient. 
Empirical studies of the magnitude of bankruptcy costs are almost non-existent. Warner(1977) in a study of 11 railroad bankruptcies between 1930 and 1955 estimates the average costs of bankruptcyas a fraction of the value of the firm three years prior to bankruptcy to be 2.5% (with a range of 0.4% to 5.9%). The average dollar costs were $1.88 million. Both of these measures seem remarkably small and are consistent with our belief that bankruptcy costs themselves are unlikely to be the major determinant of corporate capital structures. it is also interesting to note that the annual amount of defaulted funds has fallen significantly since 1940.


The analysis in this paper can be viewed as a small first step in the direction offormulating an analysis of the supply of markets issue which is founded in the self–interested maximizing behavior of individuals. They showed why it is in the interest of a wealth–maximizing entrepreneur to create and sell claims such as debt and equity. It appears that extensions of these arguments will lead to a theory of the supply of warrants, convertible bonds, and convertible preferred stock. They are not suggesting that the specific analysis offered above is likely to be sufficient to lead to a theory of the supply of the wide range of contracts in the world at large. They believe that framing the question of the completeness of markets in terms of the joining of both the demand and supply conditions will be very fruitful instead of implicitly assuming that new claims spring forth from some (costless) well head of creativity unaided or unsupported by human effort.
The publicly held business corporation is an awesome social invention. Millions ofindividuals voluntarily entrust billions of dollars, francs, pesos, etc. of personal wealth to the care of managers on the basis of a complex set of contracting relationships which delineate the rights of the parties involved. The growth in the use of the corporate form as well as the growth in market value of established corporations suggests that at least, up to the present, creditors and investors have by and large not been disappointed with the results, despite the agency costs inherent in the corporate form.Agency costs are as real as any other costs. The level of agency costs depends, amongother things, on statutory and common law and human ingenuity in devising contracts. Both the law and the sophistication of contracts relevant to the modern corporation are the products of a historical process in which there were strong incentives for individuals to minimize agency costs. Moreover, there were alternative organizational forms available, and opportunities to invent new ones. Whatever its shortcomings, the corporation has thus far survived the market test against potential alternatives.Furthermore, the analysis of this paper would seem to indicate that to the extent thatsecurity analysis activities reduce the agency costs associated with the separation of ownership and control, they are indeed socially productive. Moreover, if this is true, we expect the major benefits of the security analysis activity to be reflected in the higher capitalized value of the ownership claims to corporations and not in the period–to–period portfolio returns of the analyst. Equilibrium in the security analysis industry requires that the private returns to analysis (i.e.,portfolio returns) must be just equal to the private costs of such activity,71 and this will not reflect the social product of this activity which will consist of larger output and higher levels of the capital value of ownership claims. Therefore, the argument implies that if there is a non–optimal amount of security analysis being performed, it is too much72 not too little (since the shareholders would be willing to pay directly to have the “optimal” monitoring performed), and we don’t seem to observe such payments.

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