Corporate capital structure in the context of value-centred corporate leadership

Posted on:Apr 6,2020

Defining optimal corporate capital structure is not only relevant from the point of view of finance or financing, but also from the aspect of corporate leadership. The present study aims at presenting research on the economics of contracts focusing on reducing the effects of the conflicts of interest, and also contractual transaction costs with a special emphasis on the links between corporate capital structure and financial management. In other words, the aim of the study is to present the theory of principal-agent and transaction cost hierarchy in the context of value-centred corporate leadership.

1. Introduction

In a broad sense, an undertaking as a business activity aims at earning profit and wealth. Therefore, one of the most important expectations of owners is profit and corporate value maximisation. This can be achieved by the effective use of resources provided to companies by their creditors. Thus, it is the task of the financial management to make their investment decisions in this light by giving answers to questions concerning when, in which instrument and how much capital they should invest. Afterwards their task is to identify alternative financial solutions that ensure the capital needed for the implementation of investment in the most beneficial way possible. This can be the capital produced by the company, but in many cases a company acquires financial sources by means of redistributing outside savings, surplus cash. Evidently, capital coming from an external source entails costs – just like own capital does –, consequently, finding the optimal ratio is important to ensure efficient, economical and profitable operations.

Taking the (capital) costs of financing and related risks into consideration, determining the structure of available resources, that is the ratio of internal and external resources, has become a focal issue in corporate finance.

The study aims at giving a summary of research results and theories on corporate financing and corporate capital structure related to new institutional economics dating back to the 1950s, such as Williamson’s theory on transaction costs, or Jensen and Meckling’s views in the field of principal-agent theory, as well as Oliver Hart’s and Bengt Holmström’s contributions to contract theory in which they realised that contracts play a vital role in every area of our lives including economics, and that a contract appropriate for both parties is probably the only way of resolving the conflict of interests. Holmström did in-depth research on pay for performance, which in terms of corporate finance is linked with the principal-agent issue. Hart’s complementary work on inevitably incomplete contracts draws attention to unexpected scenarios, such as the possibility of loss of expected profits or insolvency.

The theoretical bases for creating shareholder value, that is, the returns and maximisation of capital invested by owners, were laid down in Alfred Rappaport’s work. It is also worth mentioning the Economic Value Added (EVA) model, a measure of a company’s financial performance based on economic value added, which draws leaders’ attention to adding value, focusing on cost-effective management (Pataki et al., 2015) and is able to express investment, risk and cost in one single indicator (Mester et al., 2017).

Therefore, all research results representing the views of new institutional economics have significant postulations in terms of corporate capital structure. The present study intends to provide a general picture – solely from a theoretical point of view – about the relationship between the above theories and corporate capital structure, i.e. to give a summary on the application of the economics of contracts, principal-agent theory and transaction cost theories in corporate finance, all in the context of value-centred corporate leadership.

2. The Economics of Contracts

As already mentioned in the Introduction, the economics of contracts is closely related with the names of Oliver Hart and Bengt Holmström, who were jointly awarded the 2016 Nobel Prize in Economic sciences by the Royal Swedish Academy of Sciences. Their research is centred on how contracts in economic life contribute to reducing the effects of conflicts of interest, minimising contractual transaction costs.

The Civil Code defines contract as a mutual and unequivocal statement by the parties including obligation for provision of service and entitlement for claiming service. In fact, these services refer to some (economic) event, transaction, and contracting parties may refer to, depending on the subject of the agreement, employers and employees, sellers and buyers, leaders and subordinates, as well as owner and manager, which are usually contractual relations based on contracts of services. Principal-agent relationship is established between people or groups when principals transfer their right of representation over their ownership or other interests to an agent or a group of people acting as an agent (Williamson, 1988).

In fact, the principal-agent theory focusing on contractual relations is based on the economics of incentives, mathematics and game theory. It seeks to answer the question of how principals can promote their interests through an agent under asymmetric information, pursuing self-interest and bounded rationality. From the point of view of capital structure the theory is relevant when ownership is separated from management. In this case the owner as principal delegates its rights of decision-making to the management, i.e. the agent; therefore the principal-agent theory is also relevant to the corporate management approach.

The basic situation is that a principal delegates its previously defined rights in the lack of time, resources, abilities or knowledge to an agent, but a conflict of interests arises between the principal and the agent. The principal-agent theory seeks answers to alleviate or resolve these conflicts – in the form of contracts. Therefore, the agent theory refers to the network of contracts inside the company and with its partners, which are signed to regulate the economic activities of the contracting parties (Lukács, 2005).

Besides the conflict of interest between parties, another problem for principals is the monitoring of agent activities, as well as their differences in risk tolerance. The principal’s aim is to effectively influence agent activity in order to promote their own better interests. Two types are differentiated:

  • behaviour-oriented contracts
  • outcome-oriented contracts

In the case of behaviour-oriented contracts agent activities are rewarded by salary/wage and their position in the organisational hierarchy. Principals are characterised by monitoring agent work and learning about it in detail.

Outcome-oriented contracts offer performance-related rewards to agents, such as commissions, participation in dividends or even company shares. Principals focus on measuring and assessing agent activities, however, performance-independent but correlating indicators such as share price (Holmström- Tirole, 1993) can also be taken into consideration when rewarding agents (management).

Given that agents are pursuing their self-interest, it is important that principals are in possession of appropriate information, to be able to avoid moral hazard and adverse selection. In this case moral hazard refers to cases when efforts are not traceable and the agent intentionally does not prefer representing the interests of the principal (Kóczy-Kiss, 2017). Adverse selection could be when the agent provides false information about their professional knowledge and expertise and the principal has no means of checking the data (Rosta, 2012).

According to Eisenhardt (1989) based on the above, three are two solutions to the principal-agent problem. In the first case the principal examines agent behaviour and develops information systems inside the company which measure agent performance continuously and objectively. In the other approach, the principal focuses on outcome and performance. Decisions about the two solutions are mainly based on the costs involved, however, from the point of view of risk-taking Eisenhardt (1989) said that when the agent exhibits risk-averse behaviour, behaviour-oriented contracts are more beneficial than outcome-oriented ones, whereas the latter is a better choice when the principal is more risk-adverse. Besides the above, the length of the relationship also has to be taken into account in decision-making, since in the long run principals have better opportunities to get to know the agent; while in the short term objective performance measurement may prove more effective.

Another solution is giving agents ownership; thereby the interests of the two parties move closer to each other. It has to be mentioned though that the more ownership an agent has, the less relevant their employee interests become (Kóczy- Kiss, 2017); therefore the appropriate proportion of management ownership plays a significant role.

A slight criticism of the principal-agent theory is that it has not created a model for the quantification of agent costs yet (Lukács, 2005), and it fails to consider that drawing up a contract is costly in itself (Hart, 1995).

Fransman (1994) criticises the theory more strongly, saying that companies cannot be regarded as a form of market, thus contracts cannot be used as regulating tools.

2.1. The principal-agent theory from the point of view of corporate capital structure development

Jensen and Meckling (1976) were the first to deal with the connection between capital structure and the principal-agent problem, and they identified two sources of conflict. On the one hand, a conflict of interests may arise between the owner and the management; on the other hand, between shareholders and bondholders.

These conflicts of interest that appear during company operation could affect not only financial decision-making, but also asset management, investment decisions and dividend policy.

In investment issues the conflict stems from the difference in risk-taking levels. While the management are interested in less risky investment to lower the risks of going bankrupt, owners prefer more risky projects in the hope of larger returns.

When it comes to financing decisions, company leaders still aim at avoiding the risks of bankruptcy, maintaining liquidity; therefore, for them lower credit is optimal. In contrast it is in the interest of owners to utilise the tax shield reductions through taking on higher credit.

As regards distribution of profits, the difference lies in the fact that shareholders are interested in increasing the value of shares through increasing dividends, while management seek to increase reinvested profit (Szemán, 2015).

It has to be noted that shareholders and management – besides investors and different interest groups (suppliers, buyers, governmental and non-governmental organisations), corporate culture and ethics and external relations – also have a key role in research on companies as the most influential factors on corporate financial strategies (Zéman–Tóth, 2017).

2.1.1. The owner-management conflict

In this scenario the owner is the principal, whereas the manager is the agent. The aim of the owner is company value maximisation and high dividends, while managers and company leaders are interested in maintaining liquidity, avoiding bankruptcy; ultimately, the operation of the company. This brings about further conflict situations, for instance, managers decide on investment even if its capital requirements can only be provided at the expense of dividends, or they are unwilling to liquidate a company even if the net value of assets is higher than the market value of the company (Szemán, 2015).

There might be cases when the agents clearly use company assets (company car, luxury office equipment, above average benefits) for their own benefit instead of ensuring efficient company financing. In this case, – as mentioned earlier – a solution could be increasing manager ownership in the company (Kóczy- Kiss, 2017).

Another solution is the so called “invisible hand” effect, which in the present example could be interpreted in terms of managers being forced to take the interests of the principal into consideration in their work, as their value in the managerial labour market is determined by their performance at previous workplaces (Lukács, 2005).

2.1.2. The shareholder-bondholder conflict

With regard to corporate bond issuance, neither the shareholder nor the company leader is interested in corporate value maximisation, only in the increase of own capital. The basis for the conflict between shareholder and bondholder is that shareholders prefer the implementation of high-risk projects, whose above-normal nominal returns are mostly withheld for financing company operation and growth. If the project fails to realise the expected results, the losses are borne by the bondholder.

According to Szórádiné (2005) the following examples demonstrate the source of conflict between owners and creditors:

  • In a pre-bankruptcy state, owners often force the implementation of new investments to improve profitability. As a consequence, creditors bear most of the risk.
  • If company performance or investment outcomes are lower than expected, i.e. company value decreases, the risk of interest and capital repayment for creditors grows, whereas the margin value decreases. The creditor has to change the debtor’s credit rating, which, due to increasing interests or margin calls reduces the owner’s cash flow.
  • In the case of a new credit with available margin, borrowing divests value from the owner of the old asset.
  • Decreasing liquidity due to the payment of dividends or share repurchasing entails new credit rating, which has the consequences detailed above (Harris–Raviv, 1991; Lang et al., 1996; Ross, 1996).

When the principal-agent relationship is formed, – both in the case of credit financing and bond financing – costs related to agent activity also appear, “since leaders as decision-makers always have a more in-depth knowledge of the company’s current situation, its future opportunities, the level of risk and real value than outside investors or even the creditors, and usually they use their information advantage to their own benefit” (Balla, 2006).

As for equity financing, agent cost are due to the conflict of interest between leaders and owners, such as:

  • costs of increased level of comfort when a leader becomes too comfortable,
  • cost of leader control (expenditure incurred on decreasing the previous cost),
  • costs of adopting inappropriate investments,
  • opportunity costs of missing out on favourable projects.
  • To reduce the above costs, a possible solution is increasing debt stocks in the company’s capital structure so that leaders have less free assets for financing “wastage”.
  • In the case of loan financing these costs may be the following:
  • the risk of adopting risky but high-yield investments,
  • control costs,
  • at a high level of indebtedness shareholders are unwilling to invest capital even in positive net present value projects (opportunity cost) (Krénusz, 2007).

Share capital agent costs are maximal when a company leader does not own any company shares. The higher a leader’s rate of shareholding is, the less agent costs become. Loan capital agent costs are the highest when a company’s operation and growth is financed entirely with credit. Deleveraging reduces loan capital agent costs as well. The optimal debt-to-equity ratio is at the conversion point of the two costs.

3. Economics of transaction costs

The first person to deal with the economics of transaction costs was Coase, who received the Nobel Prize in 1991 for his discovery and clarification of the significance of transaction costs and property rights for the institutional structure and functioning of the economy. Later, Williamson was also awarded the Nobel Prize (2009) for his analysis of economic governance, which also included the study of transaction costs.

Transaction costs theory defines every economic event as a transaction, and it postulates that the costs of every single transaction can be exactly determined. The study of transaction costs became necessary as a result of company growth in size, given that growth entails the expansion of business relationships and an increase in the number of transactions. The question is how companies can reduce and minimise these transaction costs for the benefit of the company and further growth (Lukács, 2005). A possible answer is drawing up proper all-encompassing contracts. However, in reality, contracts are not all-inclusive, and they are often revised and renegotiated (Hart, 1995).

Transaction costs theory focuses on ex ante modifications and ex post, post-contractual costs, and also aims at developing the most efficient organisational structures in which actors are able to minimise costs even without being fully informed and amid uncertainty which stem from the organisational specificities of production processes and the sales of the final products (Kozenkow, 2011). Therefore, the economics of transaction costs help decide in an uncertain world of incomplete information which activities are to be performed within organisational frameworks and which should be left to market forces (Rosta, 2012).

3.1. Transaction costs and corporate capital structure

In the theory of corporate capital structure, there are several approaches whose majority disregards transaction costs for reasons of simplification. In contrast, the so called hierarchy theory is specifically based on costs arising from corporate financing. The hierarchy theory built on asymmetric information is based on the assumption that company leaders have more information concerning company value than outside investors. This means that during investment financing company managers seek sources that are the least dependent on the level of information difference (Drobetz et al., 2006). The hierarchy theory does not determine an optimal debt-to-equity ratio, only determines the order of their use. According to the theory, companies rank sources based on their acquisition costs, and only turn to the next financing source in the order when the previous one is depleted. Based on this, companies prioritise internal financing (balance sheet earnings, amortisation, working capital reduction, sale of fixed assets) and external sources are only secondary. However, even when using external sources, companies seek safety. First, they issue corporate bonds, or may decide on obtaining a loan, which is followed by using hybrid securities, and the last source of financing is issuing shares (Hegedüs- Zéman, 2016). In an alternative approach, we can say that “companies seek to minimise the additional transaction costs of financing when choosing their capital structure” (Szemán, 2017).

4. Summary

One of the main aims of the present study was to present the effect of optimal leverage on corporate value from the point of view of new institutional economics. In this light, following a general theoretical introduction, the factors influencing capital structure were examined in two areas.

Based on the contract theory, or in other words, principal-agent theory, it can be concluded that the conflict of interests between parties may be mitigated, albeit not eliminated by drawing up and complying with appropriate contracts. Moreover, it is without doubt that just like everything else, agent activities have costs, which vary according to the different financing solutions. Based on this it can be said that optimal leverage is at the minimum point of loan capital and share capital agent costs.

As regards transaction costs, an objective leverage ratio cannot be determined; they play a role in prioritising the use of financing sources instead. According to the theory, companies rank financing sources based on their transaction costs and only turn to the next source in line when the source higher in the rank is depleted.

In addition to the above, the study discussed the links between capital structure decisions and corporate management, which can be defined in connection with corporate and management goals, and, ultimately mean the maximisation of corporate and equity value.


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Tóth Róbert
Chief Economist, PhD candidate, Szent Istvan University, Hungarian Chamber of Commerce and Industry,

Gyurcsik Petronella
Economist, PhD candidate, Szent Istvan University, National Tax and Customs Administration – Head of Department,

Dr. Karabassov Rassul
Candidate of Sciences in Economics. Associate Professor Acting. Republic of Kazakhstan, S.Seifullin Kazakh Agro Technical University,