Corporate Financing and Human Behavior in Finance
Corporate Financing and Human Behavior in Finance part 2
Ethical behavior is a necessary condition for shareholder wealth maximization as opposed to profit maximization. Do you believe the goal of the firm is always consistent with ethical considerations? What would you do if you could implement an unethical (and undetectable) action that would increase firm value? Hint: Review Agency Theory below and conduct external research (as applicable).
Influence of Agency Theory
A literature review of certain aspects of agency theory (Ezelle, 2011) contends the following:
Lessening the effect of agency problems can be accomplished by offering incentives to the agent to align actions comparable to what is desired by the principal or by monitoring the behavior of the agent. Either effort to mitigate the agency problem has agency costs which are classified as bonding costs, agency costs, or residual costs (Eisenhardt, 1989; Jensen & Meckling, 1976; Ross, 1973). Monitoring costs would include those activities owners or lenders consider necessary to oversee the agent behaviors and control agent costs by means of auditing, implementation of internal controls, creation of various policies and procedures, and implementing budgeting so as to protect their investment. Bonding costs are those agency costs which provide the owners some form of security to curtail the agent acquiring benefits from the firm by auditing, requiring agent insurance, and contractually limiting the agent’s authority. The residual costs are the losses which will occur when incentives exist for the agent to consume perquisites of the firm which benefit the agent to the detriment of the principal.
The conflict between the owner as principal, and manager as agent, can be framed in a branch of the economic theory of games, agency theory. Agency theory is concerned with the design of contracts which are used in the motivation of rational agents to act on the behalf of the principal when the interests of the agent would conflict with that of the principal. In effect the modeling of a firm composed of a large number of owners and managers with conflicting interests is analogous to the separation of ownership and control of a firm which is composed of a single owner and a single manager.
• Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57-74.
• Ezelle, R.W., Jr. (2011). The impact of the Sarbanes Oxley Act on auditing fees: An empirical study of the oil and gas industry (Doctoral dissertation, Touro University International). Retrieved from http://search.proquest.com/docview/906498462
• Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.
• Ross, S. A. (1973). The economic theory of agency: The principal’s problem. The American Economic Review, 63(2), 134-139.
Fabozzi, F. J. & Peterson Drake, P. (2009). Finance: Capital Markets, Financial Management, and Investment Management. New Jersey: Wiley. Retrieved from EBSCO eBooks in the Touro Library. (See Chapter below).
• 9: Financial Management