Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure

Jensen and Meckling develop a theory of why a firm’s ownership structure – the mix of inside equity held by the managing owner, outside equity, and debt – is not irrelevant, by defining “agency costs” as the sum of the monitoring expenditures a principal incurs, the bonding expenditures an agent incurs, and the residual loss from the remaining divergence between the agent’s decisions and those that would maximize the principal’s welfare. Using a formal model of a manager who sells off a fraction of his firm’s equity, they show that selling outside equity gives the manager-owner an incentive to consume more non-pecuniary benefits at shareholders’ expense, but that rational, unbiased outside buyers anticipate this and pay correspondingly less for their shares – so that the entire fall in firm value from the agency relationship is borne by the selling owner-manager himself, not pushed onto outside buyers. A parallel model of debt financing shows that once bonds are outstanding, equity holders have an incentive to shift to riskier, lower-value investments to expropriate value from bondholders (an incentive bondholders again price in at the time of lending), generating a second, separate category of agency cost alongside monitoring and bankruptcy costs. Because the agency costs of outside equity rise with the fraction of the firm sold to outsiders while the agency costs of debt rise with leverage, the paper argues the firm’s capital structure is set where the sum of these two cost schedules is minimized, which the authors treat as a genuinely novel, testable theory of optimal capital structure rather than an aside to Modigliani-Miller irrelevance. The paper’s broader redefinition of the firm itself – “simply one form of legal fiction which serves as a nexus for contracting relationships” rather than a single rational actor – is offered as the foundation for explaining, among other things, why managers hold concentrated personal stakes, why lenders impose covenants, and why voluntary accounting disclosure and auditing arise.

Michael C. Jensen | Macro Paper Warehouse

Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure