CLASS NOTES ON CORPORATE FINANCE3.pdf

TOPIC 3: AGENCY MODELS OF CAPITAL STRUCTURE
1. Introduction
2. The agency cost of outside equity
The first paper that opened the black box called the firm, was the seminal paper of Jensen and Meckling
(JFE, 1976). In this paper they look more closely at the investment decisions made by those who run the
firm and show that external financing distorts these investment decisions. The cost associated with these
distortions are called agency cost since the decision makers are agents for investors. The Jensen and
Meckling paper is actually divided to two parts. In the first, Jensen and Meckling provide a model that
shows that equity financing leads to an agency distortions and a second part provides another model that
shows that debt financing also leads to agency distortions, although the nature of these distortions is
different from the distortions created by outside equity.
In this section we consider the following version of the first model in Jensen and Meckling. An
entrepreneur establishes a firm in period 1 and needs to decide how much to invest in the firm. The
entrepreneur has initially R dollars. If he invests all the money in the firm, then in period 2 the return
on investment is V(R), where V is an increasing and concave function so that V’(.)>0>V"(.). Moreover
to ensure that the entrepreneur’s problem has an interior solution we shall assume that V’(0) = ∞ and
V’(∞) = 0. The entrepreneur does not need to invest all of R and can decide to spend some of it on perks,
like having an expensive office, taking expensive business trips, investing in pet projects that are not
productive, and receiving high wages. If we denote by I the amount of money that the entrepreneur
chooses to invest, the amount left for perks R-I. Assuming for simplicity that the utility of the
2
entrepreneur from perks is linear in the amount of perks he consumes, the entrepreneur’s problem in
period 1 if there is no external financing can be written as follows:
(1)
T