Corporate Finance Case Study

Corporate Finance (ICM251): Assessed Essay

(a) What are the agency costs of debt and outside equity as described in Jensen and Meckling (1976) and are they important in corporate finance?

According to Jensen and Meckling (1976), the specification of individual rights defines how costs and rewards will be allocated in any organisation. The contracts between the owners (the principals) and managers (the agent) of the firm will also define who is responsible for each specific costs and rewards.

In the assumption that both parties, the principal and the agent, are utility maximizers’, here is a possibilities that they have divergent interests and conflicts of interest will arise as the principal wish for the agent to run the company in a way

Corporate finance is all about management sources of fund which are separated into two, debt and outside equity. When the firm is solely funded by equity, high cost of capital, or by debt, financial distress or bankruptcy cost, the firm will not reach the optimal capital structure. The combination of debt and equity, trade-off capital structure, should be used and the matter of agency costs must be reduced to maximise value of the firm. The trade-off between tax benefit and bankruptcy cost has already been discussed as if the firm’s debt usage becomes high enough, the marginal increase in the tax shield will be less than the marginal increase in the bankruptcy cost. Agency costs consist of monitoring costs to observe the firm 's executives by shareholders, management 's bonding costs to assure owners that their best interests maximisation value of the firm, and residual losses that result even when sufficient monitoring and bonding exists. Adding additional debt reduces agency costs to equity holders because the manager can buy out outside equity using debt financing as the leverage effectively shifts some agency costs to

The first one is on the percentage of non-executive directors (NXRATIO). There are many studies that support the use of non-executive directors as they are more likely to act on behalf of shareholders. As a consequence, the greater the percentage of non-executive directors on the board, the lower Agency costs, as the first hypothesis. Secondly, duality (DUALITY) is unenviable as it gives one person a potential ability to disrupt the decision-making process of the firm, hence the separation of CEO and chairman should reduce agency costs. Thirdly, the setting up of board subcommittees. There are several board subcommittees, but only nomination committee, which contains non-executive director(s), will be focused on. As mentioned previously, a non-executive director should acts on behave of shareholders, the presence of a nomination committee (NOMCOM) and the presence of an executive director on the nomination committee (NOMXD) should reduce agency costs. The length of the CEO tenure (CEOTENURE) is considered as the longer term he/she is in the office the more power will be, agency costs are escalated as a result. The last hypothesis is the higher the number of additional directorships held by the CEO (BUSYCEO), the lower agency costs because of the higher reputation and the positive impact on firm performance. McKnight and Weir (2009) do not construct hypotheses only on board characteristics,