Efficient Market Hypothesis

The quote shows a strong relation to the efficient market hypothesis (EMH), as it implies that the costs of capital are dependent from the amount of information given by the company.

According to my opinion, agency theory is a good explanation for costs of capital. Agency theory defines contracts as under which one party – called principal – engages another party – called the agent – to perform service on the principal’s behalf. Concluding, the principal delegates decision-making authority to the agent.

Both sides of the contract are utility maximisers and the agent will not necessarily act in the principal’s best interests. This leads to the rise of agency costs. Agency costs are the welfare reduction by the principal due to the divergence of the interest.

There are three agency costs (1) monitoring costs, (2) bonding costs, and (3) residual loss.

(1) Monitoring costs are the costs of monitoring agent’s behaviour. They are expenses of the principal to measure, observe, and control the agent’s behaviour. Good examples for monitoring costs are auditing costs. To protect themselves of huge monitoring costs principals are bearing the costs to agents. An example can be given in lending: A high-risk company has high monitoring costs, which leads to a high interest rate. Another example would be the reputation of the manager: Has he got a bad reputation, than his salary would be lower than usual. Agents try to reduce monitoring costs by installing mechanisms to guarantee that they will behave in the interest of the principal or by proposing to compensate principals for their losses.

(2) The mechanisms mentioned above are bonding costs, because they are the costs of bonding the agent’s interest to the principal’s. Quarterly financial reports are bonding costs, namely the time and effort invested to generate the financial report. Agents will normally weigh bonding costs with monitoring costs and chose the cheaper alternative.

(3) Despite bonding and monitoring costs, it is still likely that agents’ interests will not correspond exactly with the principals’. If the manager is not motivated and does not invest his whole efforts, than his actual work output is lower than it would be, if his interests were exactly the same as principals’ ...

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