Examination of the Cost of Equity Paper Critque

The paper develops a theory that costs will rise as a firm expands from the three elements of property rights, agency, and finance structure. A firm’s ownership structure is derived from a market force investigated in the concept of agency and its relationship to “separation and control” along with the nature of agency costs generated by debt and outside equity being invested. Agency costs are spread about between all owners and this will reflect attitudes one would have about a firm if his costs were lowered.

An owner has complete control of a firm and its property rights; pecuniary and non-pecuniary benefits as the sole-proprietor. However, having limited funds might or not enough funds to bring an idea to market can impede the growth of a firm and the owner’s pecuniary benefits. The addition of other owners however introduces a cost in the loss of a vision because other owners might differ in viewpoints about the direction of the firm and entire control along with complete future claims on assets. In addition the new owner occur a cost on monitoring the owner-manger. “Prospective minority shareholders will realize that the owner-manager’s interests will diverge somewhat from theirs; hence the price they will pay for shares will reflect the monitoring costs and the effect of the divergence between the manger’s interest and theirs.” (11)

The authors state that the fractional loss on these claims will reduce the behavioral incentives of a founder. “The most important conflict arises from the fact that as the manger’s ownership claim falls, his incentive to devote significant effort to creative activities such as searching out new profitable ventures falls.” (12) This action would cause concern for the new investors because part of the investment in a firm is also an investment into it’s managers ability to produce future profits. I also disagree with this viewpoint which will be discussed later on in this paper.

The problem of agency relationship raises costs of monitoring by the owners and bonding costs along with a divergence of from the principal’s ideas. These relationships and not limiting relationships to just employees but also expanding it to suppliers, customers and creditors are contractual in nature. “The problem of agency costs and monitoring exists for all of these contracts, independent of whether there is joint production in their sense.” (8) These costs of agency will vary from firm to firm and depend on the tastes of managers, and their ability to exercise their own preferences as opposed to value maximization. The more managers own preferences are acted upon instead of the share holders the more agency costs are occurred.

The larger a firm gets from outside financing the more Agency costs it the firm will incur. The agency cost are spread more between the owners as the entire costs of agency rise. The agency cost of debt will rise similarly as the amount of outside financing increases. The larger the firm becomes, the larger the total agency