Introduction
Major corporate financing decisions center round selecting in between equity and debt financing. Finance managers sourcing funds for any new capital projects are likely to look at borrowing options, as such decision may not lead to cutting of dividends or to make a rights issue of equity. The decision to borrow mostly would be taken to achieve shareholder objectives of wealth maximization. Taking financing decisions need a clear understanding of the agency problem. Agency problem deals with the separation of ownership and control of a firm when perceived from a financial context. This essay briefs some ideas on the agency problem and its impact on the capital structure of a firm.
The agency problem
There is the likelihood of personal conflicts to arise where ownership and management are separate from each other. The ownership of large corporations is usually widespread with number of shareholders contributing to the share capital of the corporation. However, the management of the day-to-day operations is left in the hands of a few managers. These managers may or may not have a small stake in the equity of the company. This situation may give rise to potential problems of managerial incentives. Jensen and Meckling explored this phenomenon in detail. They have developed a theory of firms under agency arrangements. According to this theory, managers in effect are considered as agents of the shareholders. Therefore, the managers are expected to act in the best interest of the shareholders. However, the managers are entrusted with the operational control of the business and the shareholders’ knowledge about the status of the business would be very little.
According to Jensen and Meckling if the owner himself controls the operations of a wholly owned firm, he will take business decisions, which will maximize the profits of the business. A company form of business can be viewed as a set of contract, in which the shareholders are the principals and the managers represent the agents. In an efficient agency-contract the full decision, making authority over the invested capital is left to the managers with the risk of such authority being misused. However, the managers when left to them may not act in the best interests of the shareholders, unless they are provided with appropriate incentives and controls to exercise proper care on the utilization of firm assets to the best advantage of the shareholders. This gives rise to some costs, which may be termed as agency costs. Thus, agency costs represent the difference between the returns that are likely from an efficient agency contract and the actual returns, considered within the constraint that the agents (managers) may act more in their own interests than in the best interests of the principal (shareholders).
Capital Gearing
Debt and equity are the two components of the capital structure of a firm. Debt funds represent the amounts borrowed by the corporation for executing its capital budgeting decisions. Most of the companies borrow money on a long-term basis either from banks or other financial institutions or by the issue of loan bonds. The terms of the loan usually contain the amount of the loan, interest rate, duration of the loan, payment of interest and repayment of the principal. Equity capital on the other hand is a form of long-term finance contributed by the shareholders of the company. By subscribing to some portion of the share capital, any person can become a shareholder of a company and in turn will assume a certain degree of control on the affairs of the company. The portion of the profits of the company remaining after meeting the financial obligations of operating costs, interest on loans, taxation and dividend represent a part of the equity and is normally belonging to the equity shareholders.
The finance manger of a firm can choose the proportion of equity funds and loan funds to build the capital of the company. He has to consider the payment of interest and repayment of loan, which are contractual obligations of the company. On the other hand, the payment of dividend for the equity shareholders is purely discretionary, which is normally decided by the board of directors of the company. The monitoring of the capital structure of the company is denoted by the financial term ‘gearing’. The term ‘capital gearing’ indicates the proportion of borrowed capital in the overall capital structure of the firm. There are some distinct advantages of using borrowed funds. Debt capital is relatively cheaper as the pre-tax rate of interest will normally be lower than the rate of expected return by the shareholders. This is due to the legal position of the lenders, as they stand in priority to the shareholders in the distribution of the company’s income. In the event of the liquidation of a firm, the lenders have a prior claim on the assets of the company in liquidation before the shareholders can claim anything.
According to Jensen and Meckling, when the manager owns only 95 percent of the stock, he will have a tendency to use the resources of the company to the extent where the marginal utility derived from one dollar of the company’s money sent equals the marginal utility of an additional 95 cents in a dollar of the general purchasing power. This implies that the managers will act in such a way that the firm is efficient to the extent of meeting their personal interest in the firm.
Though the finance manager is free to choose the proportion of debt and equity funds, he is under an obligation to consider the relative cost of both forms of financing while deciding on the optimum capital structure of the firm. While interest on borrowed funds represents taxable expense, which is a distinct advantage from the taxation angle, it is also a fixed commitment on the part of the company. Excess of borrowed funds (high gearing) is also not advisable in view of the fact that it affects the market standing of the company.
Conclusion
This essay presented a brief outlook of the agency problem and its impact on the capital structure of a firm. In widely held companies where the shareholders cannot get an update on the day-to-day management of the company’s affairs, they have to depend on the ability of the managers. It is nothing but usual that the managers in such situations would act more to satisfy their personal interest than to safeguard the interests of the shareholders. The company form of business organization represents an agency contract in which the shareholders are the principals and the managers are the agents. The essay also looked at debt and equity financing and their relative position in the capital structure of a company. Capital gearing is seen as the proportion of debt funds in the total capital base of the company and the finance manager has to consider the relative cost of equity and debt funds in arriving at an optimum capital structure of the company.
Works Cited
Jensen, M C and W H Meckling. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.” Journal of Financial Economics October (1976): 305-360.