Managerial Ownership Theory

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

Summary

This papers investigates the theory of property rights and the theory of finance to develop a theory of the ownership structure of the firm. the concept of 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 also provides a new definition of the firm, and show how our 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 analysis

There are some unanswered questions for the existence of corporate form

1) Why it is difficult to understand the historical fact of enormous growth in equity in such organizations, not only in the United States, but throughout the world ?

2) How does it happen that millions of individuals are willing to turn over a significant fraction of their wealth to organizations run by managers who have so little interest in their welfare?

3) why are they willing to make these commitments purely as residual claimants, i.e., on the anticipation that managers will operate the firm so that there will be earnings which accrue to the stockholders?

4) Why, if non-manager-owned shares have such a serious deficiency, have they not long since been driven out by fixed claims ?

There are some reasons for not observing large corporations individually owned with a tiny fraction of the capital supplied by the entrepreneur in return for 100 percent of the equity and the rest simply borrowed in the agency cost of debt

(1) the incentive effects associated with highly leveraged

If the owner-manager has the right to decide which investment program to take, and if after he decides this he has the opportunity to sell part or all of his claims on the outcomes in the form of either debt or equity, he will be indifferent between the two investments . If the owner has the opportunity to first issue debt, then to decide which of the investments to take, and then to sell all or part of his remaining equity claim on the market, he will not be indifferent between the two investments .

It is important to emphasize that bankruptcy and liquidation are very different events. The legal definition of bankruptcy is difficult to specify precisely it occurs when the firm cannot meet a current payment on a debt obligation OR one or more of the other indenture provisions providing for bankruptcy is violated by the firm.

The firm with a high probability of bankruptcy will also find that it must pay higher salaries to induce executives to accept the higher risk of unemployment Computer industry is the best example of the demand function for the firm’s product will not be independent of the probability of bankruptcy.

The agency associated with debt consists