The Agency Cost Problem Or Principal-Agent Problem Essay

The Agency Cost Problem or Principal-Agent Problem, which is believed, arises from the separation of ownership and control, could be mitigated in many ways. In their paper Jensen and Meckling (1976) mention that if a company fully owned by its managers, they will work on maximizing its value. But if a fraction of this equity owned by managers is sold to outsiders, the risk borne by them now will have fewer fractions than before. This will be one of the main reasons for management to act on maximizing this recent percentage owned of the firm rather than maximizing the full dollar amount owned before. Outside shareholders realizing this problem tend to bear the cost of the equity owned with the addition of the monitoring costs over management and effect of difference between management’s interests from theirs. They further suggest that this conflict of interest could be resolved by many ways, like auditing, budget restrictions, control systems and establishing incentive programs, where the last one could help aligning the interest of the management with those of the shareholders, which by turn will maximize the
Too many studies helped in revealing the role of debt financing on the influence of the corporate investment decision.
In Myers (1984) a very important aspect in financing behavior called Pecking Order Theory is acknowledged, where he pointed out that corporate financing has some kind of a hierarchical characteristic. According to his theory, in order to finance a project, a firm first uses internal cash or retained earnings; if not sufficient then the firm issues debt and lastly issues equity (Myers & Majiluf, 1984; Friend & Lang, 1988; Rajan & Zingales, 1995). Retained earnings are on top of the list as they are not as costly as debt and equity; besides requires no information disclosure for the