Introduction to Corporate Finance

13: Capital Structure

financial structure.^8 Jensen and Meckling observed that when entrepreneurs own 100% of the shares

of a company, there is no separation between corporate ownership and control. Entrepreneurs bear all

the costs and reap all the benefits of their actions. Once entrepreneurs sell a fraction of their shares to

outside investors, they bear only a fraction of the cost of any actions they take that reduce the value of

the company. This gives entrepreneurs a clear incentive to, in Jensen and Meckling’s tactful phrasing,

‘consume perquisites’ (for instance, goof off, purchase a corporate jet, frequently tour the company’s

plant at Port Douglas or become a regular business commentator on television).

By selling a stake in the company to outside investors, entrepreneurs lower the cost of consuming

perquisites (or ‘perks’), but this does not come free of charge. In an efficient market, investors expect

entrepreneurs’ performance to change after they sell stakes in their companies, so investors reduce the

price they will pay for these shares. In other words, entrepreneurs are charged in advance for the perks

they are expected to consume after the equity sale, so entrepreneurs bear the full costs of their actions.

Society also suffers because these agency costs of (outside) equity reduce the market value of corporate assets.

We are therefore at an impasse. Selling shares to outside investors creates agency costs of equity, which

are borne solely by the entrepreneur, but which also harm society by reducing the value of corporate

assets and discouraging additional entrepreneurship. On the other hand, selling external equity is vital

for entrepreneurs and for society at large, because this allows companies to make investments that

exceed an entrepreneur’s personal wealth.

Using Debt to Overcome the Agency Costs of Outside Equity

Jensen and Meckling shows how using debt financing can help overcome the agency costs of external

equity in two ways. First, using debt, by definition, means that less external equity must be sold to

raise a given dollar amount of external financing. Second, and more important, employing outside debt

rather than equity financing reduces the amount and value of perquisites that managers can consume.

The burden of having to make regular debt-service payments serves as an effective tool for disciplining

corporate managers. With debt outstanding, excessive perk consumption may cost managers control of

their companies if they were to default. Because taking on debt shows a manager’s willingness to risk

losing control of her company, if she fails to perform effectively, shareholders are willing to pay a higher

price for a company’s shares.

Agency Costs of Outside Debt

If debt is such an effective disciplining device, then why don’t companies use maximum debt financing?

The answer is that there are also agency costs of debt. To understand these, keep in mind that, as

the fraction of debt in a company’s capital structure increases, bondholders begin taking on more

of the company’s business and operating risk. However, shareholders and managers still control the

company’s investment and operating decisions. This gives managers a variety of incentives effectively

to steal bondholder wealth for themselves and other shareholders. The easiest way to do this is to float

a bond issue and then pay out the money raised to shareholders as a dividend. After default, the

bondholders are left with an empty corporate shell, and limited liability prevents them from trying to

collect directly from shareholders.

8 See Michael C. Jensen and William H. Meckling, ‘Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure’, Journal

of Financial Economics 3 (October 1976), pp. 305–60.

agency costs of (outside)

equity

The value-reducing actions

that managers take when

ownership (by shareholders)

is separated from control by

managers

Our company is thinking of

issuing bonds and using the

proceeds to buy back shares.

What issues should we

consider in evaluating this

move?

thinking cap

question

LO 13.3

agency costs of debt

Costs that arise because

shareholders and bondholders

have different objectives