AGENCY THEORY

Agency theory

Agency theory

Introduction

Agency theory is the branch of financial economics that looks at conflicts of interest between people with different interests in the same assets. This most importantly means the conflicts between:

shareholders and managers of companies

Shareholders and bond holders.

Agency theory explains, among other things, why:

Companies so often make acquisitions that are bad for shareholders.

Convertible bonds are used and bonds are sometimes sold with warrants

Capital structure matters.

Agency theory is rarely, if ever, of direct relevance to portfolio investment decisions. It is used to by financial economists to model very important aspects of how capital markets function. However, investors gain a better understanding of markets by being aware of the insights of agency theory.

One particularly important agency issue is the conflict between the interests of shareholders and debt holders. In particular, following a more riskier but higher return strategy benefits the shareholders to the detriment of the debt holders.

It can easily be seen why debt holders lose out: a more risky strategy increases the risk of default on debt, but debt holders, being entitled to a fixed return, will not benefit from higher returns. Shareholders will benefit from the higher returns (if they do improve), however if the risk goes bad, shareholders will, thanks to limited liability, share a sufficiently bad loss with debt holders.

Capital Structure

The Agency theoryof capital structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. Agency theoryof capital structure basically entails offsetting the costs of debt against the benefits of debt.

The Agency theoryof capital structure discusses the various corporate finance choices that a corporation experiences. The theory is an important one while studying the Financial Economics concepts. The theory describes that the companies or firms are generally financed by both equities and debts. Agency theoryof capital structure primarily deals with the two concepts - cost of financial distress and agency costs. An important purpose of the Agency theoryof capital structure is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing.

Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work led to an optimal capital structure which is given by the trade off theory. According to Modigliani and Miller, the attractiveness of debt decreases with the personal tax on the interest ...