Contract Theory Vs. Four Control Theory

3.1.4 Control theory

Corporations are combinations of contracts from the perspective of contract theory. The investors of corporations have ownership for the investment in the corporations. Investors become owners of corporations because of the ownership of investments. They have the right to collect the benefit of corporation and the right to allocate the resources of corporations. Since the incomplete contract theory has been invented, Grossman and Hart (1980) researched from the perspective of control right of property. They defined the control right as two kinds of rights: the specific control right and residual control right. The specific control right is the property control right which is clearly defined in the contract. The residual

This lowers the risk and cost of refinancing in the future. However, reserving the excessing cash holding raises the opportunity cost and is not a good choice for increasing the wealth of shareholders. What’s more, when free excessing cash exists in a corporation with no restrains, the moral hazard of internal managers will be a threat. The free cash increased the conflict of interest in the corporation which is between senior managers and shareholders, as well as between the controlling shareholders and minority shareholders. The market value of the excessing cash holding also decreases in capital market, which means each one dollar in the excessing cash holding is worthy of less than one dollar in the market. If there is such a discounting rate, r, and the cash holding value is V. The market value of the excessing cash holding is (1 - r)V. The value of discounting rate r depends on the level of agency issue inside the corporation. The level of agency problem has a positive correlation with

This operation avoids the discount of the value of cash holding caused by agency problems. In reality, the cash holding payback policy decreases the possibility of interest conflict, whereas the wealth of shareholders could merely increase. The result of some researches shows that the inside managers or controlling shareholders would choose to enforce their “self control” (Myers, 1998) if the corporate does not distribute the excessing cash holding to shareholders. Thus, limiting the excessing cash holdings in corporation could decrease the agency cost and maintain the market value of excessing cash. Nevertheless, the distribution of cash holding is influenced by the legal protection for investors. In the countries with higher level of legal protection for investors, the distribution ratio of cash holding is higher and more constant. On the contrary, in countries with weak legal protection for investors, the distribution ratio of cash holding is lower and less constant (La Porta et al.,