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Agency Problems
Jensen and Meckling (1976): Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure
Agency Costs of Outside Equity

In this paper managerial behavior, agency costs and the ownership structure
are modelled.
The manager who is also the (part) owner of the firm can choose the amount/value
of perks (fringe benefits) F he/she wants to consume paid by the company.
Think of the fringe value F as the market value of the manager’s consumption
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of perks like plush office, jets, thick carpets, golf memberships, etc paid by
the company [keep the pecuniary compensation, salaries, fixed].
Say that V̄ is the firm value if the manager consumes no perks, and let V̄ − F
be the market value given that the manager consumes F fringe benefits (we
assume that 0 ≤ F ≤ V̄ ).
The owner-manager initially owns all shares. Suppose the manager sells a
fraction 1 − α of the firm’s shares (0 ≤ 1 − α ≤ 1). Say the the manager
utility for "money" and fringe benefits is given by U(m, F ). So the manager’s
utility is U(αV + S, F ), where α is his stake in the firm valued at V, plus the
value of the stake sold to outside investors S, and F are his fringe benefits.

V · · · value of the firm

S · · · the selling price (1 − α)V
F · · · value of perks

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Assumptions:

1. U : R2 → R fulfills the usual technical conditions U ∈ C 2, U1 > 0, U2 > 0

and U is concave, i.e. D2U is negative definite.
2. Manager (owner) maintains control

Consider for now a fixed level of α.

An equilibrium is a level of F ∗ and a selling price S ∗ such that:

1. F ∗ ∈ argmaxF U(α(V̄ − F ) + S ∗, F )
2. S ∗ = (1 − α)(V̄ − F ∗)

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Remarks:

• "For a claim on the firm of (1 − α) the outsider will pay only (1 − α)

times the value he expects the firm to have given the induced change in
the behavior of the owner-manager."
• D is chosen if α = 1.
• A is maximum if α < 1 and the outsider buy the stake at V ∗.
• A is to the right of D.
• Equilibrium is the point B.
• Note that from the equilibrium condition 2 follows
α(V̄ − F ∗) + S ∗ = α(V̄ − F ∗) + (1 − α)(V̄ − F ∗) = V̄ − F ∗
which means that the manager ultimately internalizes the loss in market
value associated with fringe benefits.
• α fixed ⇒ slopes are fixed in equilibrium. Lines have to intersect and be
tangent to utility.
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Agency costs: Manager can consume more perks (F ) but has to pay the
price in a loss of utility.
maxU(α(V̄ − F ) + S ∗, F )
F
Assume interior solution:

FOC : −αU1(α(V̄ − F ) + S, F ) + U2(α(V̄ − F ) + S, F ) = 0

U2(α(V̄ − F ) + S, F )
−α = −
U1(α(V̄ − F ) + S, F )

SOC: α2U11(α(V̄ − F ) + S, F ) − αU12(α(V̄ − F ) + S, F ) −

αU21(α(V̄ − F ∗) + S, F ∗) + U22(α(V̄ − F ) + S, F ) = 0
The SOC is equivalent to
µ ¶µ ¶
U11 U12 −α
(−α, 1) < 0 :⇒: max
U21 U22 1
| {z }
negative definite
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Comparative statics analysis

The FOC in equilibrium (S ∗ = (1 − α)(V̄ − F ∗)):

H(α, F ∗) := −αU1((V̄ − F ∗), F ∗) + U2((V̄ − F ∗), F ∗) = 0

That is, for each α the equilibrium fringe benefits is given implicity by
−αU1((V̄ − F ∗), F ∗) + U2((V̄ − F ∗), F ∗) = 0.
dF ∗
dα using the implicit function theorem ( ∂H(α,F
∂F
)
6= 0)

>0
∂H(α,F ∗ )
z }| {
∗ ∗ ∗
dF ∂α U1(V̄ − F , F )
= − ∂H(α,F =
dα ∗)
∂ 2U
∂F ∗
∗2
|∂F
{z }
<0
If α ↑ then F ∗ ↓. (the more shares the manager retains the less consumption
of fringe benefits).
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Let ξ(α) be the equilibrium utility level of the manager given α.
ξ(α) = U(V̄ − F ∗(α), F ∗(α)) indirect utility
à !
∗
0 ∗ ∗ dF (α) ∗ ∗ dF ∗(α)
ξ (α) = U1(V̄ − F (α), F (α)) − + U2(V̄ − F (α), F (α))
dα dα
dF ∗(α) £ ∗ ∗ ∗ ∗
¤
= −U1(V̄ − F (α), F (α)) + U2(V̄ − F (α), F (α)) > 0
| dα
{z } | {z }
<0 <0

⇒ α = 1 is maximizing ξ(α).
Results:

dF ∗(α)
1. <0 The higher is α the lower are the perks.
dα
dξ(α)
2. >0 The higher is α the higher is the manager’s utility.
dα
The manager pays the price in equilibrium. He can not distribute the costs to
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the buyer of the firm. In equilibrium U(V̄ − F ∗, F ∗). This is the agency
costs of outside equity.

Agency costs for debt: Asset Substitution - Risk Shifting

Intuition:
Consider a risk neutral economy with rf = 0.

• Case 1: The firm is equity only. The manager has a riskless project that
is worth 70. There is another risky project that pays
½
100 with prob 0.5
0 with prob 0.5
The manager will not replace the original project with the risky project
with lower NPV of 50.
• Case 2: The firm has debt with face value of 50. The original riskless
project has NP V = 20 for shareholders. The alternative project pays to
shareholders 50 in good state, and 0 in bad state with equal probability,
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 so has NP V = 25. Manager chooses second project even though it had a
lower NPV than the first project.

More risky projects ⇒ more volatility ⇒ call value higher ⇒ equity is higher.

More generally consider a risk neutral manager that can undertake a riskless
project with return x0. The manager can also undertake a project x̃ with
another uncertain project with returns distributed over [0, H] according to a
c.d.f. G and density g > 0. The firm has debt with face value F ∈ [0, H).

• We assume that the manager represents the shareholders. The return to

shareholders in the case that the original project is kept is
Y1 = max(x0 − F, 0)
x0 for sure.
If the project is replaced they get:
Z H
Y2 = (x − F )g(x)dx > 0
F
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which is the expected value of the risky project x̃.

• If x0 ≤ F (Y1 = 0) there will be replacement because y2 > 0.
RH
• If x0 > F the project will be replaced if F (x − F )g(x) : dx > x0 − F .

Therefore, the project will be replaced iff:

Z H
x0 < xc(F ) = F + (x − F )g(x)dx
ZFH Z F
=F + (x − F )g(x)dx − (x − F )g(x)dx
0 0
Z F
= F + x̄ − F − (x − F )g(x)dx
Z F0
= x̄ + (F − x)g(x)dx
|0 {z }
risk premium (expected loss to debtholders)

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where xc(F ) is the critical value. The case of equity only would lead to
xc(0) = x̄. In this case the risk premium would be 0. The risk comes from
asset shifting ⇒ Capital Structure Risk.
Using Leibneitz’s Rule (see below)
Z f2(x) Z f2(x)
d
f (x)dx = f 0(x)dx + f20 (x)f (f2(x)) − f10 (x)f (f1(x))
dx f1(x) f1 (x)
we get the following:

Z F Z F
d
(F − x)g(x)dx = g(x)dx = G(F ) > 0
dF 0 0
⇒ the risk premium is increasing in F . ⇒ The higher the F the less efficient
is the replacement rule.

• How does the inefficiency effect the value of the firm?

The higher the debt the lower the value of the firm because of the project
substitution.
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Debt Overhang Problem:

Myers (1977): Determinants of Corporate Borrowing.
How does the debt of the past effect your current decision?
M & M: capital structure does not change investment decisions.
Assumptions:

• No taxes, no bankruptcy costs, risk free rate of 0.

• The real state of nature s will be realized in period 1.
• Let q(s) > 0 on [0, ∞) be the equilibrium price of a dollar delivered in
period 1.
• The manager acts on behalf of the current shareholders.
• At t = 0 the capital structure is determined.
• The manager decides whether or not to invest I in a project that delivers
V (s) in period 1.
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 • The manager knows the state before he invests, so it knows the project
has a positive NPV project or not.
• For simplicity assume that the firm has no assets in place, only grwoth
opportunities.

Consider first the case of no debt:

Vg is an option on assets in place and VE is spent, for example, on R & D

(opportunity).
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If the manager wishes to invest he must issue new shares to raise I dollars
and the value of the firm will be

The manager will take the project iff V (s) ≥ I. Let’s assume that V increases
in s so V (sa) = I Z ∞
V = (V (s) − I)q(s) : ds
sa

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Now consider the case in which it is possible to issue risky debt with face
value P > 0.
The firm cannot issue safe debe (because the firm is worth nothing is states
s < sa).

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The maturity of the debt is important here. The following two cases are
considered (in all cases the state of nature s is observed before the maturity
of debt and the investment decision needs to be made).

• Case 1: The debt matures before the investment decision is made.

• Case 2: The debt matures after the investment decision is made.

Case 1:
The manager will undertake the project iff V (s) ≥ I + P .

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On the other hand, if V (s) < I + P then the debt holders take over the firm.
They will issue and invest iff V (s) ≥ I.

Z ∞
VD = min{V (s) − I, P }q(s)ds
Zsa∞
VE = max{V (s) − I − P, 0}q(s)ds
sa Z ∞
V = VD + VE = {V (s) − I}q(s)ds
sa

⇒ M & M holds.
Case 2:
If the firm raises the amount I ans exercises its investment option, its balance
sheet wtill be:

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The manager will undertake the project iff V (s) ≥ I +F (Let V (sb) = I +F ).

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Therefore,

Z ∞
VL = {V (s) − I}q(s)ds
Zsb∞
VU = {V (s) − I}q(s)ds
Zsa∞
VD = P q(s)ds
sb

⇒ VL < VU , M & M does not hold. There is an inefficiency because the

debtholders can not discipline the managers. (there are no bankruptcy costs).

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The reason is “Debt Overhang”. The debt of the past effects the financing
decision of the managers.

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Moral hazard

• Follow Tirole’s basic model

• Risk neutrality
• Entrepreneur has assets A
• Needs to invest amount I
• Project pays R in success state, 0 in failure state
• Entrepreneur can choose to work or shirk
— if work, Pr(success) = pH
— if shirk, Pr(success) = pL
— non-pecuniary gain of shirking is B
— (interpretations: B is private benefit of taking another – inferior
project)

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• Assume
— project is positive NPV: pH R − I > 0
— shirking is negative NPV: 0 > pLR − I + B
• So need to give entrepreneur incentive to work
• As usual, if no limited liability, no problem – entrepreneur pays lender I
in both states
• With limited liability: Contract is just payment Rl to lender in success
state
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 — (given risk neutrality, nothing gained by having lender pay borrower
in failure state)
• So IC constraint is
pH (R − Rl ) ≥ pL (R − Rl ) + B
i.e.
B
Rl ≤ R −
∆p
• So maximum expected pledegeable income is
µ ¶
B
pH R −
∆p
• Note: Less than project income pH R – so potential for distortion away
from first-best
• Project is financed iff
µ ¶
B
I − A ≤ pH R −
∆p
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 i.e. µ ¶
B
A ≥ Ā ≡ I − pH R −
∆p
• Observe
— if A < Ā, credit rationing: Entrepreneur would like to borrower at
rate 1, but cannot.
— the critical value Ā is
∗ increasing in B
∗ decreasing in ∆p/pH
— cannot distinguish between debt and equity here.

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RISK SHIFTING

• Next, consider a closely related variant

• Entrepreneur choose between projects 1 and 2
— project 2 is
∗ riskier: p2 < p1
∗ lower expected value: p2R2 < p1R1
∗ higher success payoff: R2 > R1
• Suppose moreover that contract consists only of payment made in success
state, Rb
— why can’t Rb differ between R1 and R2? Precise success payoff may be
unobservable, non-verifiable, or impossible to appropriate
• Entrepreneur chooses project 1 iff
(R1 − Rb) p1 ≥ (R2 − Rb) p2

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 i.e.
p1R1 − p2R2
Rb ≤
∆p
• So pleageable income is
µ ¶
p1R1 − p2R2
p1 < p1R1
∆p
• Problem is that debt-like contract induces entrepreneur to choose high-
risk projects
• If we could make Rb depend on R, easy to avoid problem
— could set Rb (R2) = 0
— or just Rb (R) = αR

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