How Leverage Affects Agency Cost : Investigating a Non-linear relationship in Pakistani Firms

This study tests the agency cost hypothesis that use of debt decreases agency cost. This relationship has been tested using data of 265 non-financial companies listed on Karachi stock exchange during the period of 2004-2009. Assets utilization and General& Administrative expense ratio are used as proxy to measure agency cost. As suggested by Jensen and Meckling (1976) that relationship between leverage and agency cost may not be monotonic and excessive high leverage may have positive effect on agency cost. To test this possibility non-linear regression model has also been included. We find evidence in support of agency cost hypothesis. Results show that total debt reduces agency cost. We also find some evidence of non-linear relationship between total debt and agency cost. In Pakistan nonfinancial companies at total debt ratio of above 60% the diminishing effect of leverage on agency cost starts to diminish and regression results give some evidence that further increase in leverage increases total agency cost. This study also provides implication for the debt holders as well as the policy makers on the use of debt in total financing of a firm. Keywords: Agency cost, leverage, non-financial firms, non-linear relationship 1. INTRODUCTION In a firm which is owned and managed by a single person, no agency problem exists because there is no conflict of interests. In such a firm, manager will make decisions that maximize firm’ value because manager himself is the entitled to the value generated by business. But when business is not totally owned by its managers, as in publicly held large corporation, there exists agency problem due to separation of control and ownership. The managers of a company act as agent of shareholders. The Shareholders of a company appoint managers to run business on their behalf. Managers have their own incentive such enjoying perquisites and maximizing their wealth (Grossman and Hart, 1982) even at the expense of shareholders’ value. As manager’s ownership claim falls, his incentive to create value of firm decreases (Jensen and Meckling 1976; Ang et al. 2000), which gives rise to the agency conflict as the goals of owners and managers become divergent. Now, question exists that how shareholders (owners) can make managers to act in their best interest? How interest of shareholders and managers can be aligned? There are different ways in which this agency problem can be reduced. These methods include: first, increasing managerial ownership as increased managerial ownership helps to align shareholder’ and managers’ interest (Ang et al., 2000; Fleming et al, 2005). Second, the role of ownership concentration in reducing agency cost. Large shareholders have more power to control and align the interest of managers and shareholders (Jensen Innova Ciencia Vol 4, No. 9;Sep 2012 3 IC@SCIENCERECORD.COM and Meckling, 1976). Third is the use of debt to commit managers and reduce agency cost (Grossman and Hart, 1982; Williams, 1987). According to agency theory, the higher debt ratio decreases agency cost of equity by aligning the interests of managers and shareholders. The purpose of this study is to test agency cost hypothesis that states that use of debt can reduce agency. 1.1 ROLE OF DEBT IN CAPITAL STRUCTURE: The Role of debt in capital structure has been widely studied in the corporate finance. In 1958, two professors Franco Modigliani and Merton Miller explored the new horizon of corporate finance. In their article Modigliani and Miller (1958) demonstrated that financial leverage has no effect on the value of a firm. The theory proposed by Modigliani and Miller was based on some stringent assumptions such as no effect of taxes, absence of bankruptcy costs, information symmetry, no transaction cost. But these assumptions do not hold in real world. In 1963, Modigliani and Miller demonstrated the effect of tax on firm capital structure and proposed that a firm should use maximum amount of debt to increase its tax shield. They argued that due to favorable treatment of interest payments, a firm should use maximum amount of debt. However, this theory did not consider the bankruptcy costs associated with debt, but companies do face bankruptcy costs in real world and these costs can be very high. As debt level in capital structure increases this also increases the cost of financial distress. Financial distress is a situation when a firm is not able to honor its obligations. Financial distress cost includes both bankruptcy and non-bankruptcy costs. The tradeoff theory of capital structure considers the both potential benefits and costs of using debt. According to trade off theory, optimum capital structure is one that balances the benefit of tax shield from interest, agency benefits and the cost of debt i.e. bankruptcy cost and agency cost. Therefore, the firm that wants to maximize its value will focus on offsetting benefits of debt with cost of using debt. According to static trade off theory, the target debt ratio might be identified by tradeoff between benefits and cost of debt of a single period. Second model is dynamic trade-off model, according to which the target debt ratio changes with change in benefits and cost of debt over time. As managers of Company are the agents of the shareholders of the company. They have responsibility to manage business for the benefit of shareholders. As identify by Jensen and Meckling (1976), this agency relationship between managers and owners can create agency problem. As managers are mainly interested in safeguarding their own interests like higher salaries, job security and enjoy other perquisites. According to agency theory, debt can be used as a tool to control agency conflict between shareholders and managers. 1.2 DEBT AND AGENCY COST: The use of debt impacts agency cost in several ways. First, the use of debt reduces the free cash flow available to managers (Jensen, 1986, Stulz, 1990), as promised interest payments to debt holders decrease free cash flow available for investment. This decrease in free cash flow also helps in curtailing overinvestment problem (Harvey et al., 2004; D’Mello and Miranda, 2010). Second, use of debt can increase monitoring of managers by debt holders like bank, which put pressure on managers to run business profitable (Ang. et al., 2000). Third, by increasing the threat of bankruptcy because in case of bankruptcy managers will lose benefits which they get form firm (Grossman and Hart, 1958; Williams, 1987). Free cash flow is the excess of cash that is required to fund all positive NPV projects (Jensen 1986). Managers have discretion to use free cash flow and this creates potential agency conflict. Managers can use free cash flow for enjoying perquisites or invest this free cash flow to increase resources under their control for empire building (Jensen, 1986; Stulz, 1990). This empire building would allow managers to create higher salaries and would offer greater power to them. This investment by managers creates overinvestment problem. Overinvestment refers to a situation in which managers invest in too many projects even when projects don’t benefit shareholders. This conflict created by free cash flow can be controlled by using debt in capital structure. By issuing debt, the managers of firm are obliged to make periodic payments of interests and principal. These periodic payments reduce amount of free cash flow available for use by managers and hence reduces agency conflict between owner and managers. Innova Ciencia Vol 4, No. 9;Sep 2012 4 IC@SCIENCERECORD.COM The use of debt also increases monitoring of managers’ activities. As creditors have incentive to monitor to performance of the enterprise (Jensen and Meckling 1976) to ensure the payment of interest and principal. Banks, which are the major source of financing, play very important role in optimizing the monitoring of managers. Large debt holders also have contractual right to monitor activities of manager. This monitoring by creditors also helps owners in monitoring managers and reduces cost of monitoring managers by owners. The other effect which is created by debt is the threat of bankruptcy. The threat of bankruptcy forces managers to run business in profitable manner. The creditors have legal right to take a firm to court if it fails to honor the claims of creditors. This creates threat for managers of losing their jobs in the event of liquidation of the firm. The threat of losing jobs put pressure on managers to run business profitably and stops them from exploiting the resources of business. The use of debt limits the tendency of managers to use firm’s resources inefficiently. In this way debt helps in disciplining manager and forces them to purse business value maximizing goals. In summary the use of debt helps in reducing agency cost in many ways and this reduction on agency cost leads to overall higher firm value. 1.3 AGENCY COST OF DEBT: The use of debt also have agency cost associated with it. Jensen and Meckling (1976) pointed out another agency problem that arises due to conflict of debtors and shareholders. As use of debt in financial structure increases, it aggravates agency problem between shareholders and debt holders. The agency costs associated with excessive increased leverage include direct wealth transfer (Smith and Warner 1979), the asset substitution problem (Jensen and Meckling 1976), and underinvestment problem (Myres 1977). The wealth transfer conflict arises when dividend of shareholders are increased or when firm issues high priority debt (Smith and Warner 1979). If a firm issues new debt which is senior to existing debt, the value of existing debt will decrease as larger number of debt holders will have claim on assets and cash flow of firm. The asset substitution problem occurs because in case of high leverage, the shareholders have strong incentive to invest money in projects with high pay-off even when probability of success is slim. As debt ho