Enter your keyword


Problems of agency theory and the role of effective financial management

Example Assignment on agency theory and the financial management 

Part A.

Critically evaluate the need to manage capital structure effectively in maximising the wealth of business organizations


The link between capital structure and product market competition refers to the relationship that may or may not exist between the mix of financial securities chosen by the firm to evidence its ownership and the manner in which the firm behaves in its product market. Capital structure is a term of art, referring to the mix of financial securities issued by a firm both in exchange for and as evidence of the contribution of an investor’s cash or property. Product market competition refers to the product market interaction of rivals. How does the link between capital structure and product market competition come about? It is no more complicated a notion than having the strategic product market decisions of the firm affected by its financial position.

effective financial management


Take the seller of a single good that engages in its product market as well as in the capital market. The price, or cost, of capital is some rate of return the firm must pay investors in order to separate them from their cash. In particular, a firm that chooses to raise capital by selling an interest in its equity incurs a cost of equity, and the firm that chooses to raise capital by borrowing from investors and issuing debt incurs a cost of debt. The question arises as to whether the firm can arrange its capital structure so as to minimize its total cost of capital. In their seminal work, Modigliani and Miller (1958) consider this question within the context of an economy with, among other things, perfect markets. They show that in the absence of a corporate income tax the cost of capital and firm value are independent of capital structure. However, Modigliani and Miller implicitly assume that the product market is perfectly competitive such that operating profit is given to the firm. As such, they do not consider whether, in equilibrium, the firm’s operating profit responds differently to various mixes of debt and equity.

So what happens if one endogenizes operating profit? The question then becomes whether a firm’s capital structure can affect its product market behavior and, thus, the product market equilibrium. Clearly, this question is moot for a perfectly competitive market where any one firm’s behavior does not affect the market equilibrium. For oligopolies, however, the question is of some importance because, if a link is forged between a firm’s capital structure and its product market behavior and, therefore, the product market equilibrium, firm value is no longer independent of financing. An obvious implication is that a firm contemplating changing its capital structure may first want to consider two interdependent questions. First, how will this change likely affect competition in the product market and second, given the answer to the first, what is going to happen to the firm’s own value? The literature on the link between capital structure and product market competition in imperfectly competitive markets stands as an exception to the famed Irrelevance Proposition of Modigliani and Miller.

Having discussed whether financial structure can affect competition, we now briefly turn to how financial structure can affect competition. The effects of financial structure are usually classified as either competitive or collusive. That is, to the extent that financial structure causes firms not to maximize operating profit, the question becomes whether levered firms behave more or less competitively. If more, then financial leverage is regarded as having pro-competitive effects, but if less, then debt is regarded as fostering collusion, or softening competition. Empirical research on this topic, by and large, has come down on the side of collusion. This is not surprising given that most public issues of securities that include debt are composed of long-term debt, which is shown in the theoretical literature to have collusive effects on product market competition.

This brings us to our contributions to the literature on the link between capital structure and product market competition. First, we extend the work of Glazer (1994), who models the simultaneous product market play of a financially leveraged duopoly and shows that long-term debt has collusive effects. We show that long-term debt may have competitive effects if issued by firms in an industry characterized by sequential product market play consistent with the presence of a quantity leader. Second, we provide further empirical support for the notion that financial leverage has collusive effects. In doing so, we analyze data from the domestic steel industry over the period 1958 to 1981. A moderately concentrated and relatively tight oligopoly over this period, the domestic steel industry looked on as its largest producers significantly increased their long-term debt obligations. To test the null hypothesis that capital structure had no effect on industry behavior, we estimate a system of demand and supply equations. By allowing a measure of capital structure to enter the industry’s supply relation, we test its coefficient for statistical significance. In finding that its coefficient is statistically distinguishable from zero, we reject the null hypothesis that capital structure had no effect on industry supply. The results provide further empirical support, along the lines of Chevalier (1995a,b) and Phillips (1995), for the notion that financial leverage has collusive effects on product market competition. Third, we test the null hypothesis of quantity leadership in the steel industry, using insights from our theoretical model. A further contribution is that we use a binomial probit to account for the possibility that product market competition may itself affect the leader’s decision to alter its capital structure, which may then affect the leader’s behavior and thus product market competition. In short, we endogenize capital structure within a model designed to test whether capital structure affects product market competition.

The literature on the link between capital structure and product market competition considers, as a threshold matter, whether a firm’s capital structure can measurably affect its product market behavior and then whether the financial positions of constituent firms can influence the overall competitiveness of the industry.

A common thread running throughout the theoretical literature is that capital and product markets are interrelated. When capital markets are perfect, leveraged firms become more or less aggressive in the product market because shareholders retain an option on the firm’s earnings that exerts an ex ante influence on their product market behavior. When capital markets are imperfect insofar as asymmetric information between investors and firms exists as to the firm’s true earnings, there is an additional incentive among so-called deep-pocketed firms to prey upon financially constrained firms in an effort to force early exit, which implies aggressive product market play and a more competitive equilibrium in the short term. Asymmetric information as to the firm’s true earnings makes it necessary for borrowers and lenders to agree upon a contract that incorporates the optimal tradeoff between minimizing managerial incentives to hide or otherwise divert earnings and deterring predation by deep-pocketed firms. Asymmetric information on the part of shareholders may also give the firms an incentive to use their product market behavior to influence shareholder perceptions and thus their share price.

Capital Structure and Product Market Competition

capital structures

To the extent a firm’s decision as to capital structure affects its optimal product market strategy, capital structure carries with it strategic implications for product market behavior. It follows that the firm’s value may indirectly depend on its capital structure. This is an interesting result for a number of reasons, not the least of which is its seeming inconsistency with one of the most influential propositions in all of corporate finance.

Modigliani and Miller (1958) propose that capital structure has no effect on firm value if markets function perfectly. Allowing firms to compete in an imperfectly competitive product market wherein each firm recognizes that its behavior affects the market price violates this assumption. Therefore, this literature stands as an exception to Modigliani and Miller’s irrelevance proposition.

Brander and Lewis (1986) use a two-stage duopoly model to consider how capital structure affects the Cournot-Nash equilibrium in pure strategies. In the first stage, a firm’s equity is normalized to, so that a debt-to-equity ratio is implicitly set by the firm’s decision as to how much debt to issue in order to finance investment. In the second stage, firms choose output to maximize the expected difference between operating profit, defined as the difference between total revenue and variable production costs, and the firm’s periodic debt obligation. The authors assume operating profit is stochastic. Shareholders of a levered firm now run the risk of bankruptcy. To understand the incentives facing holders of levered equity, one must turn to the seminal work of Black and Scholes.

Black and Scholes (1973) argue that levered-equity is the equivalent of a call option on the firm’s earnings. By the Black-Scholes formula, we know that the value of a call option is increasing in the instantaneous variance of the underlying asset. The implication is that shareholders now have an incentive to pursue risky “projects” in order to increase the volatility of earnings. In Brander and Lewis, this incentive becomes one that drives the levered firms to increase production in the face of fluctuating profit. The general result is that the more debt the firm issues the more output it produces. With debt, the firm becomes more aggressive, which forces the rival to cut production, and therein lies the strategic element of debt finance. In equilibrium, each firm carries debt in its capital structure and increases production over and above what entirely equity-financed firms would choose to produce in maximizing expected firm value. In short, Brander and Lewis allow the shareholders of two leveraged rivals to behave just as Black and Scholes predict insofar as these holders of levered-equity seek to increase the value of their call options by pursuing risky output stances through increased production in the face of fluctuating profit.


Part B: Discuss the problems of agency theory and evaluate the role of effective financial management in addressing these problems.


Firm performance is the central focus of strategic management research (Schendel and Hofer, 1979). The broad question of why firms underperform has been examined in strategic management from several theoretical perspectives, including agency theory (Jensen and Meckling, 1976). According to agency theorists, firms underperform due to the separation of ownership and control and the resulting misalignment of interests between shareholders (principals) and management (agents).

To resolve this problem, agency theorists prescribe the redesign of managerial incentives in the form of pay-for-performance compensation that induces managers to focus on shareholder value, and a more concentrated ownership structure as fewer active shareholders with higher equity stakes are more apt to effectively monitor management and curb opportunism (Jensen and Meckling, 1976; Eisenhardt, 1989).

Following redesigned managerial incentives and closer board monitoring, the firm is expected to perform to optimal. Kaplan (2007) refers to these agency-related remedies as governance engineering.

However, governance engineering may not always fully solve the problem of underperformance for at least two reasons (e.g., Hendry, 2002). The first reason is associated with the specification of objectives, known as multitasking (Holmstrom and Milgrom, 1991). When a principal’s goals are complex and multidimensional and therefore difficult to capture in an outcome-based contract, attempts to specify outcomes may be dysfunctional, as agents will perform to the specific terms linked to incentives, rather than in the more general interests of their principals. The second reason is honest incompetence (Hendry, 2002) by the firm’s management team. In agency theory, managers are assumed to be competent and always able to achieve desired outcomes provided incentives are in place.

Yet, in empirical research, the competence of individuals is not guaranteed given bounded rationality (Simon, 1957) and limitations of rational understanding and communication arising from language, culture, and cognition (e.g., Simon, 1991). In situations in which agents are called upon to exercise judgment, or in which the achievement of goals depends on cooperative efforts involving other people, outcomes are not guaranteed regardless of the effort applied (Nilikant and Rao, 1994). The issues of honest incompetence and multitasking may be reduced via advice in the form of mentoring and guidance (Hendry, 2002). Principals may dedicate effort not to monitor for opportunism, but to help agents develop their technical competence via the transfer of skills or to improve the agents’ understanding of goals beyond those specified contractually – including circumstances, values, and the broader priorities of principals.

Relatedly, the offering of advice to management has been often reported as one of the key duties of boards of directors (e.g., Mace, 1971; Carter and Lorsch, 2004).

An underlying assumption of such an advisory role is that principals must have industry-specific knowledge, operating expertise or expert networks deep enough to be considered areas of valuable advice to agents. Such valuable knowledge possessed by principals may manifest themselves in the capacity for operational engineering (Kaplan, 2007). Potential for operational engineering (POE) refers to the degree to which a firm’s operational inefficiency is higher than the competition’s, and therefore could be improved. The implication is that principals must know how to identify and act upon potential for operational engineering in order to be capable of providing valuable advice to agents. If this line of reasoning is correct, then firms in which principals and agents implement governance engineering (via redesigned incentives and closer monitoring) and operational engineering (enabled by the advisory role of capable principals) at the same time should be least likely to underperform.

It is noteworthy that operational engineering and governance engineering embody overlapping yet different concepts. They overlap as their absence may lead to similar consequences (underperformance), yet they differ as not all firms with high potential for operational engineering suffer from high agency costs. As an example, there is no separation of ownership and control in a founder-owned and managed firm, yet this firm may underperform even in the presence of profit-maximizing goals as a consequence of honest managerial incompetence.

Corporate Governance and Agency Theory

According to agency theorists (e.g., Jensen and Meckling, 1976), the separation of ownership and control in the modern corporation evidences two distinct entities with different interests and risk profiles: management (agents) and shareholders (principals). While shareholders may diversify risks by investing in multiple firms, management is tied to a single organization by virtue of their position (Fama, 1980). This difference in risk profiles means that management and shareholders operate under different sets of incentives. Jensen and Meckling define an agency relationship as “a contract under which one or more persons (the principal[s]) engage another person (the agent) to perform some service on their behalf which involves delegating some decision-making authority to the agent” (1976:308). However, it is difficult to specify ex ante contracts that accommodate all possible future contingencies (e.g., Shleifer and Vishny, 1997).

Agency theorists make the explicit assumption of self-interested individuals (Jensen and Meckling, 1976) prone to opportunism. From a shareholder’s perspective, this may lead to inefficient managerial behavior, such as: making short-term, risk-averse investments (Lambert and Larcker, 1985); empire-building (Amihud and Lev, 1981); shirking (Jensen and Meckling, 1976); exploiting managerial perks (Williamson, 1985); and ‘the quiet life’ (e.g., Stein, 2003).

To agency theorists, the corporation’s board of directors is the primary monitoring device aimed at protecting shareholder interests and alleviating potential agency problems (Fama and Jensen, 1983; Jensen and Meckling, 1976). Agency theorists posit that the primary responsibility of the board of directors is to ensure that management actions are consistent with shareholder interests (Alchian and Demsetz, 1972; Fama and Jensen, 1983). Thus, the board acts to separate decision management from decision control, keeping for itself the roles of ratification and monitoring (Fama and Jensen, 1983). Additionally, boards of directors also influence firm performance by reducing agency costs arising from noncompliance by management with established goals and procedures, by articulating shareholder objectives, and by focusing the attention of management on performance (Mizruchi, 1983).

However, severe limitations to the degree of discretion conferred to boards of directors have been widely documented (e.g., Mace, 1971; Lorsch and MacIver, 1989) even more recently (e.g., Carter and Lorsch, 2004). Finkelstein and Hambrick (1996) note that boards are not always effective monitors of management, and conclude that the underlying reason relates to the balance of power in the boardroom, which tends to shift toward the dominant CEO (e.g., Kosnik, 1987). Further, Kerr and Bettis (1987) show that boards often do not honor their fiduciary duties.

Corporate governance controls may be internal or external to the firm. Walsh and Seward (1990) argue that boards of directors have two classes of internal controls available: the adjustment of incentives, and dismissal. In case of failure of these internal control mechanisms available to boards, the market for corporate control is supposed to serve as an external mechanism and the discipline of last resort (Manne, 1965; Fama, 1980). However, external controls may also fail given a host of external entrenchment practices available to astute, opportunistic management (Walsh and Seward, 1990).

The Agency Costs of Free Cash Flows

Corporate governance scholars disagree on the effectiveness of the existing mechanisms in the United States (Shleifer and Vishny, 1997). Easterbrook and Fischel (1991) offer an optimistic assessment of the US corporate governance system, whilst Jensen (1989; 1993) argues that US listed corporations embody deeply flawed governance mechanisms. According to Jensen (1986), one of the reasons why governance mechanisms in the US are flawed is the agency costs of free cash flows.

Jensen defines free cash flow (FCF) as “cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital” (1986:323). Noting that conflicts of interest between principals and agents over payout policies are especially severe when the organization generates substantial free cash flows, Jensen (1986) examines the problem of how to motivate managers to disgorge cash in lieu of investing it in projects yielding returns lower than the cost of capital, or wasting it on other organizational inefficiencies. An underlying assumption is that free cash flows may allow corporate management (agents) to finance low-return or even negative-return projects, which would otherwise not be funded via external sources such as the equity or bond markets. FCF theory implies management in firms with unused borrowing power and large free cash flows are more likely to undertake low-benefit or even value-destroying projects. In order to test FCF propositions, Jensen (1986) examined the US oil industry, which had earned substantial free cash flows in the 1970s and the early 1980s in the aftermath of substantial increases in oil prices. The author found that, consistent with the agency costs of free cash flow, managers in the US oil industry did not pay out excess cash to shareholders. Instead, they continued to spend heavily on activities such as exploration and development in the 1980s as oil prices collapsed, even though average returns were below the cost of capital.

As a potential solution available to firms with severe agency costs of free cash flow, Jensen (1986) offered debt. Specifically, “levering the firm so highly that it cannot continue to exist in its old form generates benefits. It creates the crisis to motivate cuts in expansion programs and the sale of those divisions which are more valuable outside the firm. The proceeds are used to reduce debt to a more normal or permanent level. This process results in a complete rethinking of the organization’s strategy and its structure. When successful, a much leaner and competitive organization results” (1986:328-329).

Searches related to effective financial management

effective financial management pdf, what are financial management practices, components of financial management, 4 elements of financial management, financial management basics, explain the importance of effective financial management systems within own work setting, what is financial management all about, ten principles of financial management


Alchian A, Demsetz H. 1972. Production, information costs and economic organization. American Economic Review, 62: 777-795.

Amihud Y, Lev B. 1981. Risk reduction as a managerial motive for conglomerate mergers. Bell Journal of Economics, 12: 605-617.

Black, F., and M. Scholes (1973) “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, May-June, pp. 637-654.

Carter C, Lorsch J. 2004. Back to the drawing board. Harvard Business School Publishing: Boston, MA.

Chevalier, J. (1995a) “Capital Structure and Product Market Competition: Empirical Evidence from the Supermarket Industry,” American Economic Review 85(3), pp. 415-435.

Chevalier, J. (1995b) “Do LBO Supermarkets Charge More? An Empirical Analysis

Easterbrook F, Fischel D. 1991. The economic structure of corporate law. Harvard University Press: Cambridge, MA.

Eisenhardt K. 1989. Agency theory: an assessment and review. Academy of Management Review, 14: 195-223.

Fama E, Jensen M. 1983. Separation of ownership and control. Journal of Law and Economics, 26: 301-325.

Fama E. 1980. Agency problems and the theory of the firm. Journal of Political Economy, 88: 288-307.

Finkelstein S, D’Aveni R. 1994. CEO duality as a double-edged sword: how boards of directors balance entrenchment avoidance and unity of command. The Academy of Management Journal, 37: 1079-1108.

Glazer, J. (1994) “The Strategic Effects of Long-Term Debt on Imperfect Competition,” Journal of Economic Theory 62, pp. 428-443.

Hendry J. 2002. The principal’s other problems: honest incompetence and the specification of objectives. Academy of Management Review, 27: 98-113.

Holmstrom B, Milgrom P. 1991. Multitask principal agent analyses: Incentive contracts, asset ownership and job design. Journal of Law, Economics and Organization, 7: 24-52.

Jensen M, Meckling W. 1976. Theory of the firm: managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3: 305-360.

Kaplan S. 2007. Private equity: past, present and future. Journal of Applied Corporate Finance, 19: 8-16.

Kerr J, Bettis R. 1987. Boards of directors, top management compensation, and shareholder returns. Academy of Management Journal, 30: 645-664.

Kosnik R. 1987. Greenmail: a study of board performance in corporate governance. Administrative Science Quarterly, 32: 163-85.

Lambert R, Larcker D. 1985. Executive compensation, corporate decision-making, and shareholder wealth: a review of the evidence. Midland Corporate Finance Journal, 2: 6-22.

Lorsch J, MacIver E. 1989. Pawns or potentates: The reality of America’s corporate boards. Harvard University Press: Boston, MA.

Mace M. 1971. Directors: Myth and reality. Harvard University Press: Boston, MA.

Manne H. 1965. Mergers and the market for corporate control. Journal of Political Economy, 73: 110-120.

Mizruchi M. 1983. Who controls whom? An examination of the relation between management and board of directors in large American corporations. Academy of Management Review, 8: 426-435.

Modigliani, F., and M. Miller (1958) “The Cost of Capital, Corporate Finance and

Nilikant V, Rao H. 1994. Agency theory and uncertainty in organizations: An evaluation. Organization Studies, 15: 649-672.

of the Effects of LBOs on Supermarket Pricing.” Journal of Finance. September, pp. 1095-1112.

Schendel D, Hofer C. 1979. Strategic management: a new view of business policy and planning. Little Brown: Boston, MA.

Shleifer A, Vishny R. 1997. A survey of corporate governance. Journal of Finance, 52: 737-783.

Simon H. 1957. Models of man: social and rational. Wiley: New York, NY.

the Theory of Investment,” American Economic Review, (June), pp. 261-297.

Williamson O. 1985. The economic institutions of capitalism. Free Press: New York, NY.