Agency costs in raising capital

Literature review

In order to better understand our subject and to see what have been done so far on the subject and what are the conclusions economists and researchers came with, we studied ten articles related to the subject and found that three main topics were highlighted in most of the papers. Therefore, we decided to study and compare the different findings of these authors. We focused first on the concentration of ownership with agency cost of debt and the dividend policy, to then analyse the agency costs and leverage and finally, we had a closer look to governance and financing decisions.

First of all, we could focus on the concentration of ownership with agency cost of debt and the dividend policy. According to Ronald C. Anderson, family ownership is more common in large, publicly traded firms and is related, both statistically and economically, to a lower cost of debt financing. Our results are consistent with the idea that founding family firms have incentive structures that result in fewer agency conflicts between equity and debt claimants. This suggests that bond holders see founding family ownership as an organizational structure that better protects their interests.

However large family ownership firms are more and more uncommon and Claire E. Crutchley, Robert S. Hansen explained in 1989 that larger firms are characterized by lower managerial ownership, increased leverage, and increased dividend payout. These results are consistent with the diversification cost effect. In larger firms, liquidity costs reduce the effectiveness of managerial ownership to control agency costs, so in these firms’ managers rely more on leverage and dividends. These results are also consistent with the agency model; as managers rely less on dividends to avoid the higher equity financing costs, they rely more on ownership and leverage. Another important issue raised by Jorge Farinha concerning ownership is the level of insider ownership. Indeed, he explained that after a critical entrenchment level of insider ownership estimated in the region of 30%, the coefficient on insider ownership changes from negative to positive, which means that: within a certain ownership range, the higher insider ownership can reduce expected agency costs and hence dividend policy may decrease.

Brailsford, Oliver and Pua (2002) agree on this point with Jorge Farinha as they tried to find the relation between ownership structure and capital structure. They argue that shareholder and managements interests fit better when there is a low level of managerial share ownership in a firm. These findings are consistent with the fact that equity ownership is directly linked to the agency costs which motivates the aim of this this paper which is to examine the relation between agency costs and leverage.

Moreover, we could have a closer look to the existing link between agency costs and leverage.

Berger and Bonaccorsi di Patti (2004) use profit efficiency as a performance indicator to measure agency costs. They showed that higher leverage reduces the agency costs of outside equity and increases firm value by constraining or encouraging managers to act more in the interests of shareholders. On the other hand, relatively high leverage increases the total agency costs because it elevates the risk of bankruptcy (higher leverage means higher pressure on the management to produce the required cash-flows to repay the debtholders and a higher cost of debt). Thus, “agency costs of outside debt overwhelm the agency costs of capital. This findings can be very important to our study, as leverage has an impact on how companies will choose their financing. Therefore, we could investigate how agency costs are dependent on capital structure when a firm wants to raise capital.

In that sense, Laster (1995) provides an empirical study on agency costs’ effects on firm’s capital structure depending on the firm’s growth options. Companies with high growth options will more naturally tend to have a high level of debt, whereas the others, which are not subject to having free cash flow issues will have low debt in their resources. This study also indicates that companies are less threaten by bankruptcy when their leverage is low and that low leveraged firms are those with low managerial ownership. Those results are consistent with the work of Farinha (2003) who showed it by analyzing agency theory with beneficial insider ownership through the dividend policy, corporate governance and managerial entrenchment hypothesis. This research is important to our paper as it describes variables that could impact a company’s decision for outside financing.

We could now focus more on governance and financing decisions that could have an impact or are related to agency costs that could influence the choice between raising capital through debt or equity.

Smith (1986) and Barclay and Smith (1995) argue that managers of regulated firms can exercise less discretion over future investments decisions than managers of unregulated firms. Indeed, Mande, Park & Son (2012) demonstrated that agency costs will influence the choice of financing between debt and equity through the quality of corporate governance. Their research finds that with a strong policy, companies will be drawn to equity financing whereas companies with weak policies will rather finance their development with debt. Thus, we understand that strong corporate governance will reduce information asymmetry between top management and owners, reducing the conflict of interest and agency costs. However, this paper also implicates a size criteria suggesting that these findings are more pronounced with small firms than large corporations.

In regard to this statement, Harveya, Linsc and Roperd (2004) carried out tests of whether the agency costs linked to the asymmetry of information between managers and shareholders can be mitigated with debt using emerging markets, where expected agency costs are extreme. The results show that the debt offer an incremental benefit in terms of value for firms which have important managerial agency costs and more particularly to those having overinvestment problems due to a high level of assets or narrow growth opportunities. The decrease of agency costs doesn’t only comes from the leverage difference but particularly thanks to the higher monitoring linked to the issuance of debt. Therefore, this paper interrogates us on how and what kind of debt could be used by companies as a tool to reduce agency costs and thus, to increase shareholder’s value.

Investigating further the influence of corporate governance on debt structure, Jiraporn, Kitsabunnarat (2007) argue that the empirical evidence reveals an inverse relation between the strength of shareholder rights (measured by a “Governance index”) and debt maturity. In fact, managers working in firms with weak shareholder’s rights will prefer choosing long-term debt instead of short-term in order to minimize external monitoring. Following their study, they reveal that financing decisions are used in order to control managers when managers and shareholder’s views are divergent. So as to understand how agency costs are related to leverage, it’s crucial to understand how we can measure and determine the leverage. Thanks to this article, we know that we need to focus on the leverage, the distribution between debt and equity inside the firm, and also the structure of the debt used. Testing those variables from an agency costs perspective in our study could help us understand better what levers are used by both managers and shareholders to control the firm. Our statistical investigations will therefore use these variables to state whether or not, there is an existing relationship between agency costs and leverage.

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