Chapter 2 Theoretical Framework
2.3 Corporate governance theories
2.3.1 Agency theory
Agency theory (Jensen and Meckling, 1976), or Principal-Agent theory, is the most
important theory in relation to corporate governance, the relationship inside the firm is
defined as:
“A contract under which one or more person (the principal) engages another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent” (Jensen and Meckling, 1976:305).
In Agency theory, the managers (top management and Board of Directors) are the agents
of the shareholders and they have their own agendas; these are separate to the
shareholders who employ the managers to represent them and their interests (Fama and
Jensen, 1983). The existence of two key parties in companies, principal and agent,
ensures there are two sets of objectives, which can be in conflict with each other and can
lead to agency costs developing. Agency costs are the costs of reducing the conflict
between the agent and the principal, if the agent and the principal are the same these costs
would be zero. One such solution to reducing agency costs is through the use of good
corporate governance. In this study, variables include board share ownership, CEO
duality and the number of non-executive directors.
There are two hypotheses in relation to the relationship between shareholders and
managers; these are agency costs of equity and agency cost of debt hypotheses.
The agency cost of equity hypothesis incorporates lenders to perform a monitoring role,
36
encourages managers to focus on maximisation of value when faced with the threat of
bankruptcy (Jensen, 1986). The threat of bankruptcy is increased in companies with high
levels of debt. CEOs wish to avoid this threat, and avoid those policies that reduce
company valuation, even if they prefer different policies (Grossman and Hart, 1982). The
fixed payments associated with debt reduce a company’s free cashflow; a CEOs ability is limited to prevent the use of the company cashflows for their own benefit. The issuance
of external debt introduces a third party; for example bondholders, other lenders,
investment bankers or bond rating agencies (Ortiz-Molina, 2007). The use of debt
covenants leads to higher monitoring of the company’s performance. Debt covenants are expensive to write and enforce, however, they can limit the company’s flexibility to
respond to unexpected contingencies (Ortiz-Molina, 2007). High debt and high-powered
incentives are costly to undertake by under-diversified CEOs, and can act as substitutes
(Ortiz-Molina, 2007).
Agency theory focuses on the costs associated with the separation of ownership and
control; shareholders own the business, while the managers control the business.
Entrepreneurs who own 100% of their company have no separation of ownership from
control, agency costs are kept to a minimum, situations whereby venture
capitalists/business angels invest in the company ensure the issue of separation is
apparent again (Cannella and Monroe, 1997). Agency theory has arisen due to the
increase in public corporations that developed in the 1930s. The association with Agency
theory and the link with corporate governance was not identified until the 1970s; this
develops an agency cost of equity. The percentage of managerial ownership is important
to identify the magnitude of the agency costs of equity. The impact of a reduction in
managerial/insider ownership is the search for profitable projects may reduce; in addition,
37
misalignment of goals can lead to managers focusing their efforts on their own goals,
instead of the company goals (Jensen and Meckling, 1976). Companies use methods
such as incentive compensation systems, budget restrictions and formal systems in an
attempt to prevent and mitigate this behaviour (Fama, 1980).
Jensen and Meckling (1976) identify three reasons that prevent large companies having
capital structures containing a large percentage of debt. The first of these three reasons
surround who bears the cost of debt should a project be unsuccessful, and therefore
unprofitable. Managers who operate within companies whose capital structure contains a
high percentage of debt are encouraged, and incentivised to undertake high risk projects
with high returns. The remaining amount generated from the project, following the
servicing of the debt, is awarded to the shareholder(s). Meanwhile, should the project
fail, the costs fall to the debtholders, and therefore the balance is essential to ensure the
debt is competitive, and is in the best interests of the shareholders (Jensen and Meckling,
1976).
The second reason relates to the legal contract that exists between the debtholders, and
the company. The contract can include conditions to limit the manager’s behaviour, and avoid debtholders bearing the costs as a result of poor management decisions. One
condition is debt is required for future projects, and conditions can be attached to the
issuance of debt in the future (Jensen and Meckling, 1976).
Lastly, the increase in debt levels increases bankruptcy costs, these occur when there is a
delay to a company servicing their interest payments/obligations. During bankruptcy, the
shareholders claim is reduced to zero, the remaining loss being borne by the debtholders.
The balance between the tax related benefits and bankruptcy costs is key, an imbalance
38
The second hypothesis is the agency cost of debt; there are two conflicts of interest –
shareholder-manager and shareholder-bondholder. Managerial incentives are driven by
the need to mitigate these conflicts of interest (Jensen and Meckling, 1976). The close
alignment of the manager and shareholder’s interests enables managers to choose the investment policies that benefit shareholders, over the needs of the bondholders (Ortiz-
Molina, 2007). This creates agency costs of debt finance, due to lenders pricing debt
based on managerial incentive structures. Shareholders may have incentives to reject
positive NPV projects that benefit bondholders, while reducing the value of their equity
(Myers, 1977). The undertaking of high risk negative NPV projects can increase equity
values while reducing bond values, the relationship between managers and shareholders
depends on the equity based incentives to increase shareholder wealth (Jensen and
Meckling, 1976). Companies that contain a higher percentage of debt in their capital
structure are faced with higher shareholder-bondholder conflicts. Having a lower
alignment with their managers can reduce the agency cost of debt finance, while
increasing the agency cost of equity. The agency cost of debt and equity hypothesis
predict higher levels of debt within the capital structure, and ensure the reduction in
agency conflicts between the manager and shareholder. Secondly, it reduces the conflict
between the shareholder and bondholders (Jensen and Meckling, 1976).
Agency theory is based upon the assumption that humans are risk adverse; the investment
of their capital into corporations allows risk diversification of their wealth (Jensen and
Meckling, 1976). The two parties’ goals and motives are very different, therefore
resulting in conflicts with each other. For example, a company whose capital structure
contains a high percentage of debt will benefit from the tax shield and therefore pay less
taxation, in comparison to a company whose capital structure contains more equity.
39
retained profits that are available for the owners to be lower in the form of dividends.
One solution used in companies is to issue high dividends to satisfy the owners of the
business, shortly followed by raising finance through the issue of new shares. The costs
of this process, along with the timespan, mean this approach is not advisable. The
decision-making process is the root of the conflict; ensuring that both parties are satisfied
with the decisions being made often creates a cost, called agency cost (Jensen and
Meckling, 1976). This cost can be minimised through various ways. However, it is
simply a result of having two parties involved in the running of the business, and the rise
of this conflict has led to the development of the corporate governance theory.
There are three main agency costs; these are the monitoring expenditure which is incurred
by the principal, the bonding expenditure which is incurred by the agent, and lastly the
residual loss (Jensen and Meckling, 1976). The first cost concerns the issue of two
parties having different interests, and the process that is needed to try to align these
through the use of incentives such as share options. The second cost is called the
‘bonding costs,’ these are arrangements whereby there are penalties if the agents do not act in the best interests of the principal, while rewarding them if goals are met. The last
cost occurs when the previous two costs are not sufficient to prevent a reduction in
shareholder wealth. This is due to the ‘free-ride’ issue (Keasey et al., 1997), whereby shareholders rely on each other to monitor the company; if ownership is diffused it does
present a bigger issue.
Positive agency theorists have sought to develop ways to overcome the ever-present issue
of differing interests between the shareholders and the managers. For example, the
development of contracts, setting up of Boards of Directors, the use of labour market
theory, the use of corporate control markets and compensation levels (Cannella and
40
incentive based forms of compensation for the CEO, and those directors who form the
Board of Directors. One frequent solution is through using equity based forms of
compensation, such as share options. Issues that surround these solutions to the agency
issue surround the ability of managers to manipulate the accounting data, upon which the
compensation is based. Enron is an example of where this happened in relation to their
share price, they no longer operate and several employees served time in prison following
the scandal. Eisenhardt’s (1989) review of the solutions to Agency theory suggests that they do result in the alignment of the shareholder and managers interests. The threat of
dismissal serves as a market for corporate control; Cannella et al. (1995) find that
managers who are dismissed due to poor performance, subsequently find it difficult to
find equivalent employment following their dismissal. The labour market theory
(Cannella et al., 1995) presents more questions than it addresses; poor performance in
companies cannot be linked directly to the performance of CEO/directors. Meanwhile,
diversified shareholders expect managers to undertake risky investments on their behalf,
managers are careful to avoid risky investments in order to remain employed, leading to
managers who are more risk adverse than the shareholders (Cannella and Monroe, 1997).
Secondly, public limited companies have a reduced incentive to monitor due to the
existence of the efficient capital market hypothesis, which results in the efficient capital
market. There are two areas of conflict, the first is between the shareholders and
managers as mentioned above, and the second is between the debtholders and equity
holders (Cannella and Monroe, 1997). The first conflict arises due to managers holding
less than 100 per cent, if any, percentage in the business. The nature of taking out debt
reduces the amount of free cash flow available, as interest payments need to be made on
the amount of debt taken out. This commitment has the effect of discouraging managers
41
debatable, however, some researchers say debt can alleviate the problem, whilst others
see the issue of taking out debt as the root of the problem. For example, a high level of
debt increases the risk of default, and it is argued would improve the liquation decision.
The second conflict surrounds who benefits or carries the risk, when investments perform
well or not. If the issuance of debt results in the investment succeeding, then the equity
holders will benefit, following the servicing of the debt. In situations where the
investment fails, the debtholders bear the fallout. The agency cost of debt financing
occurs when equity holders are able to benefit from the company investing in risky
projects, which is value decreasing. The impact of these investments leads to a decrease
in the value of the debt, enabling the equity holders to gain at the expense of the
debtholders, called ‘asset substitution effect’ (Harris and Raviv, 1990).
Linked to agency cost is firstly the borrowing capacity of companies, which will depend
upon the type of assets held by a business. Assets with an active secondhand market
increase the capacity, due to security being provided by the companies who are taking out
the debt. Secondly, managerial preferences, if a company goes into liquidation the
shareholders lose their financial stake, and managers lose their jobs. The implications are
far wider and result in managers being less likely to want to increase the company’s debt
level in the future, and reduce the risk level of the company (Hermalin, 1993). The
issuance of bonuses to managers, which is based upon EPS, unlikely in periods of
recession, is another aspect to consider. Bonuses could result in managers replacing
equity in the business with debt and artificially increasing the EPS, and therefore their
bonus, placing the company at the risk of financial distress. The level of union activity in
a company is the third reason; having low levels of debt and low cash outflows may allow
42
The establishment of the Board of Directors is as a result of the two parties that now exist
within companies, and the alignment of the two parties’ goals form an agency cost
(Jensen and Meckling, 1976). The composition of the Board of Directors provides a
collection of independent variables in this study, in addition to board ownership variable.
It is the relationship of these independent variables, for example the percentage of
independent directors, with capital structure, which forms the basis of this study.