PAM_334_Fall_2008_Lecture_21 - PAM3340 Lecture21...

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PAM 3340 Lecture 21 Announcements: Final: December 18th at 2PM in Ives Hall Room 105 Will cover all lectures/guests Will NOT cover D&L; K&L; or SOX readings  Will cover all others (including merger papers) Will have one question verbatim from previous  prelims/problem sets
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Jensen and Mecking,  Journal of  Financial Economics  (1976) Goal of the paper: To integrate the  property rights literature, agency theory,  and finance theory Monitoring costs of the principal Bonding expenditures by the agent The residual loss
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The manager/entrepreneur (or sole  proprietor, or entrepreneur) gets non- pecuniary benefits from aspects of firm  operation X = x 1 , x 2 , x 3 , . . . . x n  (such as leisure,  corporate jet, charitable contributions,  thick carpets, etc.)
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(con’t) Econ 101: The manager/entrepreneur  will take those benefits to the point  where the marginal utility derived from  an additional dollar of expenditure on  each non-pecuniary item is equal  across all elements, and equal to the  marginal utility derived from an  additional dollar generated by firm  wealth
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The Agency Costs of Outside  Equity The agency costs of  outside equity Outside equity  is equity held by those  who do not manage the firm Suppose there is no outside equity: As  the manager/entrepreneur sells more  equity to outsiders, the relationship  between her rewards and her effort  decreases
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The Agency Costs of Outside  Equity The owner bears less of the wealth  effects of her decisions Say she sells (1 -  α ) (where 0 <  α  < 1)  of firm She keeps  α  fraction of firm
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The Agency Costs of Outside  Equity She bears only  α  of the wealth effects  of any decision Important aspect of agency cost: As  (1 -  α ) rises, owner/manager has less  incentive to seek out new profitable  projects, which reduces value of the firm
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Modeling Agency Costs X = vector of non-pecuniary goods from  which managers get utility C(X) = total dollar cost to the firm of  providing X P(X) = total dollar value to the firm of  productive benefits of X B(X) = P(X) - C(X) net dollar benefit to  the firm of any X
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PAM_334_Fall_2008_Lecture_21 - PAM3340 Lecture21...

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