Essays on investment and financing decisions
George Tsetsekos1986, University Microfilms International eBooks
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to my dissertation Commi ttee. I have benefi ted gre atly from the inte l ligent cri ti ci sms and patient encouragement of my dis sertation chai rman , Dr. George C. Philippatos . I wi sh al so to thank Professors Choi and Shrieves fo r their patience and interest. Thei r stimulating conversations throughout the course of thi s research enabled me to fo cus attenti o n on the centra l iss ues of thi s dissertation . In additi o n , I•want to extend my appreciati o n to Drs . Gl ustoff and Kidwel l for thei r hel pful comments . This dis sertation is the outcome of an unexpected educational excursion that I took after graduation from the NTUA. The excursion began in January 1980 wi th the unconditi onal hel p and encouragement of Dr. Peter Athanasopou los; it conti nued wi th the intel l ectual cooperation offered by Professor Nicol as Gressis; and it ended in Knoxville, Tennessee , in 1984 , wi th an enri ching and professional ly rewa rding experience provided by Dr. George Philippatos . I have only good memories from this journey . Dr. Phi lippatos , to whom I acknowl edge my indebtedness , made the end an unforgettable experience .
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University of Tennessee, Knoxville
TRACE: Tennessee Research and Creative
Exchange
Doctoral Dissertations
Graduate School
6-1986
Essays on Investment and Financing Decisions
George P. Tsetsekos
University of Tennessee - Knoxville
Follow this and additional works at: https://trace.tennessee.edu/utk_graddiss
Part of the Business Administration, Management, and Operations Commons
Recommended Citation
Tsetsekos, George P., "Essays on Investment and Financing Decisions. " PhD diss., University of
Tennessee, 1986.
https://trace.tennessee.edu/utk_graddiss/3052
This Dissertation is brought to you for free and open access by the Graduate School at TRACE: Tennessee
Research and Creative Exchange. It has been accepted for inclusion in Doctoral Dissertations by an authorized
administrator of TRACE: Tennessee Research and Creative Exchange. For more information, please contact
trace@utk.edu.
To the Graduate Council:
I am submitting herewith a dissertation written by George P. Tsetsekos entitled "Essays on
Investment and Financing Decisions." I have examined the final electronic copy of this
dissertation for form and content and recommend that it be accepted in partial fulfillment of the
requirements for the degree of Doctor of Philosophy, with a major in Business Administration.
George C. Philippatos, Major Professor
We have read this dissertation and recommend its acceptance:
Do-Young Choi, David Kidwell, Ronald Shrieves, Errol Glustoff
Accepted for the Council:
Carolyn R. Hodges
Vice Provost and Dean of the Graduate School
(Original signatures are on file with official student records.)
To the Graduate Council:
I am submitting herewith a dissertation written by George P.
Tsetsekos entitled 11Essays on Investment and Financing Decisions ...
I have examined the final copy of this dissertation for form and
content and recommend that it be accepted in partial fulfillment
of the requirements for the degree of Doctor of Philos hy, with
a major in Business Administration.
We have read this dissertation
and recommend its acceptance:
Accepted for the Council:
�.�
.....
-
Vice Provost
and Dean of The Graduate School
ESSAYS ON I NVESTMENT AND F I NANC I NG DE C I S I ONS
A Dis s e r t a tion
Pres e n ted for the
Doctor of Philo s ophy
Degree
The Un i versity of Te n n e s s ee, Kno x ville
Geo rge P. Tset s e kos
J u ne 1 986
ii
AC KNOWL EDGMENTS
T h e re a re no word s that a re s u ff i c i e nt to e x p re s s my th a n k s
to my d i s s e rta t i on Comm i tte e .
I h a v e benefi ted g re a t l y from the
i n te l l i ge n t c r i t i c i sms a n d pa t i en t e n c o u rageme n t o f my d i s s e rta t i on
c h a i rma n , Dr. George C. P h i l i ppato s .
I wi s h a l s o to t h a n k P rofe s s o rs
C h o i a n d S h r i e v e s fo r t he i r pa t i e n ce a n d i n teres t .
T h e i r s t i mu l a t i n g
convers a t i o n s t h ro u g h o u t the c o u r s e o f t h i s re s e a rc h e n a b l ed me to
fo cu s a tten t i o n on the c e n t ra l i s s u e s o f t h i s d i s s e rta t i o n .
In
a d d i t i o n , I · wa n t to extend my a p pre c i a t i o n to Drs . G l u s toff a n d
K i dwe l l fo r t h e i r h e l pfu l comme n t s .
T h i s d i s s e r ta t i on i s the o u tcome o f a n u n e x pected e d u c a t i o na l
exc u rs i o n t h a t I took a fter g ra du a t i on from t h e NTUA .
The e x c u rs i o n
began i n Jan u a ry 1980 wi t h t h e u n c o n d i t i ona l h e l p a n d e n c o u ra g eme n t
o f D r . P e t e r At h a n a s opou l o s ; i t co n t i n u e d wi t h t h e i n te l l e c t u a l
coopera t i o n o ffered by P ro fe s s o r N i c o l a s Gre s s i s; a n d i t e n d e d i n
Knox v i l l e , Ten n e s s e e , i n 1984 , wi t h a n e n ri c h i n g a n d profes s i o n a l l y
rewa rd i n g e x pe r i e n c e prov i de d by D r . Geo rge P h i l i ppato s .
on l y good memo r i e s from th i s jou rney .
I have
D r . P h i l i ppatos , to whom I
a c know l edge my i n de btedne s s , ma de t h e e n d a n u n forgetta b l e e x p e r i e n c e .
iii
ABSTRACT
T h i s d i s s e rtat i o n c o n ta i n s t h ree e s s ay s i n the a re a of B u s i ne s s
F i nance wh i c h a re re l ated t o the l i tera t u re o f a symme t r i c i n fo rma t i o n
a n d a g e n cy .
O u r purpose i s t o demo n s t ra te t h a t the p re s e nce o f
a symme t r i c i n fo rma t i o n c reates pos s i b l e co s t l y effe c t s t h a t a d v e r s e l y
i n fl u e n c e t h e performa nce a n d profi t a b i l i ty o f t h e f i rm .
The f i r s t e s s ay de a l s wi t h the v a l u e o f s l a c k
( exce s s l i q u i d i ty )
a n d the i n v e s tme nt d e c i s i o n u n d e r a symme t r i c i n fo rma t i o n .
It is
s hown t h a t when ma n a ge rs a n d s h a r e h o l d e r s h o l d d i ffe re n t i n fo rma t i o n
s et s w i t h re s pe c t t o t h e q u a l i ty of an i n v e s tme n t opportu n i ty , a n
o pt i mum amo u n t o f s l a c k c a n p a r t i a l l y re s o l ve a n u n de r i n v e s tmen t
p ro b l em .
T h e emp l oye d framewo r k emp ha s i z e s the ex i s te n c e o f a
pena l ty fu n c t i o n wh i c h i s a s s i g n e d by c a p i ta l ma rket pa rt i c i pants
due to the u n c e rta i n ty a s s o c i ated w i t h t h e a n n o u n ceme n t o f extern a l
f i n a n c i ng .
I n the s e c o n d e s s ay , we a d d re s s i s s u e s o f r i s k s ha r i n g between
a n a g e n t and a p r i n c i pa l .
We exami ne the pri nc i pa l - a g e n t re l a t i o n
s h i p u nd e r the p l a u s i b l e c o n d i t i o n o f a mu l t i d i v i s i o na l ma n a ge r i a l
e ffo r t .
I t i s s u g g e s te d t h a t u n d e r rea l i s t i c a s s umpti o n s , i n fo rma
t i o n a b o u t the d i v i s i o na l pe rfo rma n c e p ro d u c e s s h a r i n g ru l e s wh i c h
a re d i ffe re n t from those d e r i v e d u n d e r the con d i t i o n o f a g g re g a te d
i n forma t i o n .
T h e t h i rd e s s ay dea l s w i t h i s s u e s of a g e n cy c o s t s a n d f i n a n c i a l
dec i s i o n s a t t h e d i v i s i o n a l l e ve l o f a mu l t i d i v i s i o n a l f i rm .
It
iv
i s a rg u e d t h a t the i n terna l o r g a n i z a t i ona l s t ru c t u re p l a c e s some
con s t ra i n t s o n the n a t u re of the fi n a n c i a l de c i s i o n s ma de by the
d i v i s i o n ma n a ge r .
The i n tern a l regu l a to ry e n v i ronme n t fo rces t h e
d i v i s i o n a l ma n a g e r to b e ri s k a verse a nd t o a v o i d t h e a d o p t i on of
ri s ky p roje c t s .
The costs a s s o c i a te d wi t h t h i s ma n a g e r i a l behav i o r ,
c a l l ed ma n a ge r i a l regu l a to ry c o s t s , re p re s e n t a d i ffe rent d i men s i o n
o f a g e n cy c o s t s .
v
TAB L E O F CONTENTS
PART
PAGE
I NTRODUCT I ON
I.
1
THE VAL U E O F SLAC K AND THE I NV ESTME NT D E C I S I O N
U N D E R ASYMMETR I C I N FO RMAT I O N
PART I B I BL I OGRA PH Y
II.
.
42
PART I I B I BL I O G RA PH Y .
83
.
.
. . . .
F I NAN C I AL D E C I S I ONS , AGE N C Y CONS I DERAT I O NS , AND
TH E I NT E R NAL ORGAN I ZAT I ONAL STRU CTU R E
PART I I I B I B L I OGRA PH Y
V I TA
38
TH E P R I N C I PAL�AGENT MODEL U ND E R A MULT I D I V I S I O NAL
STRU CTU R E
III.
. . .
4
.
.
. . . .
.
.
. .
.
. .
87
1 12
1 15
1
I NTRODU CTION
Recent dev e l o pme n t s i n Co rpo rate F i nance have exami ned the
potent i a l c o n f l i c t s of i nt e re s t between s h a re ho l d e r s and ma nage rs
that res u l t from the sepa rat i o n o f owne rs h i p and c o n t rol.
The
age ncy t h e o ry has p rov i ded a funct i o n a l f ramewo r k w i t h i n wh i c h i s s u e s
of i n vestme n t a n d fi nan c i ng d ec i s i o n s can be a n a l yzed i n a pra c t i c a l
ma n n e r co n s i s te n t w i t h econom i c theo ry .
I nd e e d , t h e agency theory
has p rov i de d a s t rong e c o n om i c ra t i o nale that e x p l a i n s c o rporate
f i n a n c e s t ru c tu re s a n d o t h e r p ropo rt i o n s a s s o c i a t e d w i t h the c om
plex i t i e s o f mode rn f i n a nc i a l a r rangeme n t s .
Agen cy p ro b l ems a re re l at e d to i nfo rma t i o nal a symmetry among
the a c tors i n the o rgan i za t i o n .
An a rgument fo r t h e s i gn i f i c a n c e
of a symme t r i c i nfo rma t i o n i n a f i rm i s i t s pe rv a s i v e n e s s i n ma r ke t
t ra n s a c t i on s .
Asymme t r i c i nfo rma t i o n e x i sts when two o r more
age n t s i n v o l ved i n a c o n t ract h a ve d i ffe ren t i n forma t i o n set s .
By
i n forma t i on s e t we mean the s p e c t rum o f i n forma t i o n t h a t i s re l ev a n t
t o the agen t s' de c i s i on ma k i ng w h i c h i n c l udes eleme n t s s u c h a s
endowmen t s, prefe rences and beliefs .
I t is rea s o n a ble to assume
tha t a symme t r i c i n forma t i o n i s p r e s e n t i n a l mo s t a ny f i n a n c i al
t ra n s a c t i on .
Most corporate a c t i v i t i e s a re c h a ra c te r i ze d by
con t ra c t u a l a r ra ngeme n t s i n v o l v i ng c o n t i ngen t payoffs .
Argume n t s
of agency c o n f l i c t s a n d i n fo rmat i on a l a symme t ry can s u c c e s s fu l l y
be employed i n ex pla i n i ng c o rporate f i n a n c e beh a v i o r.
T h i s wo r k c o n ta i ns t hree e s s ays i n t h e a rea of Bu s i n e s s
F i n a n c e wh i c h a re re l ated to t h e l i te ra t u re o f a symmet r i c i n fo rmat i o n
�
�
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-���---
2
a n d a g e n cy .
Ou r pu rpose i s to demo n s t ra te t h a t t h e p re s e n c e of
a symme t r i c i n forma t i on c re a te s po s s i b l e cos t l y effe c t s that a d v e rs e l y
i n f l u e n c e t h e pe rformance a n d profi ta b i l i ty o f t h e f i rm .
I t i s our
obje c t i ve to d e s c r i be t h e n a t u re o f t h e a symme t ry o f i n formation ,
a s we l l a s t h e ma g n i tude o f the re s u l t i ng i neffi c i e n cy .
The f i r s t e s s ay dea l s w i t h the v a l ue of s l a c k (ex ce s s
l iq u i d i ty ) a n d t h e i n v e s tme nt de c i s i o n u nder a symme t r i c i n fo rmat i o n .
I t i s s hown that when ma n a g e rs a n d s h a re h o l ders h o l d d i ffe re nt
i n fo rma tio n s e t s wi t h re s pe c t to the q u a l i ty o f a n i n v e s tme nt
opportu n i ty , a n o p t i mum amo u n t o f s l a c k can p a r t i a l l y re s o l v e an
u n deri n v e s tme nt p ro b l em .
The emp l oye d framework empha s i z e s the
ex i s te n ce o f a pena l ty fu n c t i o n wh i c h i s a s s i g n e d by c a p i ta l ma rket
part i c i pants due to the u n c e rta i nty a s s o c i a ted wi t h the a n nou n c eme nt
of extern a l f i nan c i ng .
I n the s ec o n d e s s ay , we a d d re s s i s s u e s o f r i s k s h a r i ng betwee n
a n a g e n t a n d a pri n c i pa l .
W e ex ami n e the p r i n c i pa l - a g e n t re l a t i o n
s h i p u n de r t h e p l a u s i b l e c o n d i t i o n o f a mu l t i d i v i s i o n a l manag e r i a l
effo rt .
I t i s s u g g e s te d t h a t u n d e r re a l i s t i c as s umpti o n s , i n fo rma
t i o n a b o u t the d i v i s i on a l performa n c e p rodu c e s s h a r i ng ru l e s wh i c h
a re d i ffe re n t from those d e r i ved u n d e r the c o n d i t i o n o f a g g regated
i n fo rmat i o n .
F u r t h e r , i t i s s u g g e s te d that i n forma t i o n a b o u t d i v i
s i o n a l effort i s co n s i dered a v a l u a b l e s i g nal from t h e p r i n c i pa l 1 S
po i n t o f v i ew .
The t h i rd e s s ay dea l s wi t h i s s ue s o f a g e n cy c o s t s a n d f i n a n c i al
dec i s i o n s a t t h e d i v i s i o n a l l e v e l o f a mu l t i d i v i s i o nal f i rm .
It
3
i s a rgu e d 1hat t he i n tern a l o rga n i za t i o n a l s t ru c tu re p l a c e s some
c o n s t ra i n ts on the n a tu re of the f i n a n c i a l de c i s i o n s made by t h e
d i v i s i on ma nage r .
T h e i nterna l regu l a to ry e n v i ronme n t force s the
d i v i s i o n a l manager to be r i s k a v e r s e and to a vo i d t h e a d o p t i on o f
ri s ky pr oje c t s .
T h e c o s t s as soc i a t e d w i t h th i s ma n age r i a l behav i o r ,
c a l l ed ma nage r i a l regu l a to ry c o s t s , represent a d i ffe rent d i men s i on
of age ncy c o s ts .
Wh i l e age n cy c o s t s re p re s e n t l os s es wh i c h re s u l t
from the s e l f- i nterest beh a v i o r of man a gers when t h ey p u r s u e persona l
goa l s a t t h e e x p e n s e of s h a r e h o l ders go a l s , manage r i a l regu l a to ry
c o s t s a re t h e res u l t of the b e h a v i o r of d i v i s i on a l ma n age rs who
re s p o n d to i nt e rn a l orga n i z a t i ona l forces.
A l t h ough a l l e s s ays a re exami n i ng re l ated i s s u e s o f agency
a n d a symme t r i c i n format i on , t h e l a s t two e s s ays h a v e a s t rong
thema t i c con t i n u i ty i n that t h ey exam i n e the p r i n c i p a l -age n cy re l a
ti o n f rom two d i ffe re n t perspe c t i ves :
the c o n t ra c t i ng-agen cy
framewo r k , a n d the r i s k - s h a r i ng age n cy framewor k .
PART I
5
T H E VALUE O F SLA C K AND T H E I NV ESTMENT D EC I S I ON
UNDER ASYMMET R I C I N FORMAT I O N
I.
I NTRODU CT I ON
The tex tboo k treatme n t o f l i q u i d i ty a s s ume s t h a t l i q u i d
ba l an c e s a re t h e d i r e c t re s u l t o f t h e f i rm ' s o p e ra t i n g cyc l e.
t h e e x c ep t i o n o f a few s t u d i e s , e x c e s s l i qu i d i ty
Wi th
( s l a c k ) i s tre a te d
a s a n u n de s i ra b l e - c o s t l y a c c o u n t , presuma b l y beca u s e the fi rm c a n
i nv e s t e x ce s s l i q u i d ba l a n c e s i n p ro f i ta b l e f i x e d a s s e t s .
Sl ack
re s o u rc e s a re e x ami ned i n a f ramework w h i c h emph a s i ze s t h e perfe c t
syn c h ro n i za ti o n o f f u n d s re s u l t i ng from c u rre n t a s se t s a n d c u r re n t
l i a bi l i t i e s .
H owe ve r , s u c h a n a p p ro a c h i s c o n s i de re d myop i c bec a u s e
i t i s o l a t e s t h e va l u a t i o n o f l i q u i d a s s e t s from t h e v a l u a t i o n o f
fi x e d a s s e t s .
I n deed , t h i s s e p a ra t i on i s u nfo rtu n a te be c a u s e i t
tends t o foc u s atten t i o n o n t h e a n a l ys i s o f o n l y o n e p a rt of the
f i rm ' s rea l a s se t s .
T h i s e s s ay dea l s w i t h t h e ro l e o f exc e s s l i q u i d re s o u rc e s
i n t h e i nv e s tme n t dec i s i on.
Ou r i n te n t i on i s to a n a l yz e t h e u s e
o f s l ac k for rea s o n s other t h a n t h o se a s s o c i a te d w i t h t h e f i rm ' s
o p e ra t i n g cyc l e.
We exam i ne t h e v a l u e o f s l a c k i n t he c o n text o f
a symme t r i c i n fo rma t i on betwe e n managers a n d s h a re ho l d e r s .
P r o b l ems
of a symme t r i c i n fo rma t i o n rega rd i n g new i nv e s tme n t s force s h a re
h o l d e r s t o d i s c o u n t on a n ex-a nte b a s i s the a c tu a l v a l u e o f n ew
pro f i ta b l e opportun i t i e s .
To a vo i d u n d e rva l u a t i o n e ffec t s ,
mana g e r s c a n h o l d s l a c k re s o u rce s before the i nv e stme n t o p p o rtu n i ty
6
a ppea r s o n the h o r i zon .
Ce rta i n l y , th i s a pp ro a c h has i t s own me r i ts
whe n t h e re a re not costs of h o l d i ng s l a c k.
Howe ve r , ma i n tain i ng
s l a c k re sou rces is a n e x pe n s i ve p ro po s i t i o n .
S i n c e t h e re a re c o s t s
a n d bene f i t s o f ho l d i ng s l a c k , o u r foc u s i n th i s e s s ay is o n i de n t i
fy i ng the o p t i mum amo u n t o f s l ac k t h a t t he firm s h ou l d a l l o cate for
fu t u re i n v e s tme nt pu rpos e s .
Ou r framewo r k empha s i ze s two e l eme nts :
f i r s t , the n a t u re
o f the a symmet ry of i n fo rma t i o n t h a t a p pea rs to be the p r i n cipa l
force fo r t h e a ccumu l at i o n o f s l a c k re s o u rces ; a n d s e c o n d , the
i mpac t o f a n n o u nceme n t e ffe cts o f e x te rna l f i na n c i ng o n t h e fi rm1 s
ma rket v a l ue.
The p roposed mo del comb i nes a rgume n t s o f a symme t r i c
i n forma t i o n w i t h t radeoff effe c t s o f ex terna l fina n c i ng .
The remi n d e r of t h i s e s s ay i s div i ded i n to fou r s e c tions .
Se c t i o n I I introduces t h e c o n c e p t o f s l ac k , def i nes s l ac k a s a
s pe cia l l iq u i d a s s et , a n d high l ights its pos sib l e u se s .
A l so , in
th i s s e c t i o n we rev i ew the l itera t u re that de a l s w i th the i s s u e s
a d d re s s e d i n o u r mode l .
I n s e c t i o n I I I we i n t ro du c e a n d dis c u s s
the a s s ump t i ons o f o u r mode l .
T h e p re s e n ta tion o f the mo de l is
fo l l owe d by an in- depth ana l y s i s wh i ch c l ea r l y s hows the benefi t s
of ho l d i ng s l a c k .
I n s e c tion I V , we present t h e c o s t c on s i dera t i o n s
of o u r mo d e l , a n d we d e r i v e t h e optimum amo u n t of s l a c k.
Fina l l y ,
in secti o n V we offer s ome p o s s i b l e extensio n s of o u r wo r k a n d
rec omme n da t i o n s for futu re re s e a rc h .
7
I I.
A.
THE CONC E PT O F SL AC K
A D e f i n i ti o n
We de f i ne s l a c k a s the ex c e s s o f l i q u i d res o u r ces a l l ocated
over the m i n i mum nece s s a ry l e v e l to a c c om p l i s h the ta s k of wor k i ng
ca p i t a l man agemen t a s s i gned to a ny o rga n i za t i on .
I n t h i s contex t ,
the u n a v a i l a b i l i ty o f s l a c k may be def i ned a s a n u n d e ra l l oc a t i o n
of l i q u i d a s s e t s a n d can be s e e n as a form o f c a p i ta l ra t i o n i ng .
Sla c k h a s t h e m ea n i ng o f a n a s s e t o f re se rve l i qu i d i ty t h a t manage rs
reta i n fo r a l a te r o c ca s i o n ; i t i s u n u s e d but a v a i l a b l e i f needed
for a ny spe c i a l pu rp ose ; i t i s a sec u re p o s s e s s i on of a res e rv o i r
of l i qu i d f u n d s .
S l a c k can e i t h e r be c on s i d e re d a s a n i d l e re s o u rc e
or as a n a s s e t wh i ch i s gai n fu l l y em p l oyed i n t h e s h o rt t e rm .
F o r e x p o s i t i o n a l pu r po s e s we p re s e n t a new v i ew o f t h e
b a l a n ce s he e t .
U n d e r t h e c o n v en t i o n a l ap pro a ch , t h e a s s e t s i de
o f the ba l a n c e s h eet co n s i s t s of f i xed a s sets a n d wor k i ng c a p i t a l
a s s e t s o r c u r re n t a s s ets .
The l i ab i l i ty s i de c on s i s ts o f wo r k i ng
cap i ta l l i a b i l i t i e s a n d s h a re ho l de r ' s e q u i ty.
Wor k i ng c a p i ta l
a s s e t s a n d l i a b i l i t i e s repre s e n t t h e f i rm ' s f i n a nc i a l n e e d s wh i c h
re s u l t f rom t h e f i rm's ope ra t i ng cyc l e .
U n fo rt u n a te l y , t he s e
f i n a nc i a l needs i nc l u de e l eme n t s w h i c h a re i n f l u e n c e d by b o t h
s tra teg i c a n d o p e r a t i ng d e c i s i on s .
T he conve n t i o n a l a p p roa c h d o e s
not offer a ny d i s t i n c t i on betwee n f i na n c i a l n e e d s re s u l t i ng from
opera t i o n s , a n d f i na n c i a l needs a ri s i ng from l ong term i n v e s tme n t
( l i qu i da t i o n ) d ec i s i o ns .
T h e fo l l ow i ng new way of v i ew i ng the
8
ba l a n c e s h eet a d d re s se s t h e s e need s .
Under the new a p p roac h , t h e
a s s e t s i de of t h e b a l a n c e s he e t c o n s i s t s of t h ree e l eme n ts:
( a ) f i x e d a s se t s ( a s sets i n p l a ce ) , ( b ) wo r k i ng c a p i ta l requi reme n t s ,
wh i c h a re d i rec t l y re l a te d to the f i rm 1 S o p e ra t i ng cyc l e ( p rodu c t i o n
d i s t r i b u t i o n ) , a n d ( c ) s l a c k , w h i c h co n s i s ts of l i q u i d re s o u rc e s
n o t t i e d t o the f i rm 1 S o p e ra t i ng cyc l e des i g nated f o r fu t u re d i s c re
t i o n a ry i n v e s tmen t s .
The ri g h t h a nd - s i d e of t h e b a l a n c e s h eet
con s i s ts o f s h a r e ho l de r 1 S equ i ty , l o n g - te rm debt and requi re d wo rk i n g
cap i ta l l i a b i l i t i e s .
F i gure 1 offers a g ra p h i c a l i l l u s t ra t i on o f
the c o n v e n t i ona l a n d n e w s t ru c tu re o f the ba l a n c e s hee t .
It is
s u g g e s te d t h a t wo r k i ng c a p i ta l req u i reme n t s s u pport a s s e t s i n p l a c e
a n d a s s i s t , u s i n g a sy n c h ron i z a t i on proce s s , i n t h e smo o t h o pe ra t i o n
o f the ma i n l i ne o f bu s i ne s s .
O n t h e other h a n d , i t w i l l be a r g u e d
that s l a c k i s a f i n a n c i a l a s s e t who s e e x i s te n c e i s a s s o c i a te d wi t h
t h e f i rm 1 s fu t u re d i s c ret i o n a ry i n ve s tme nt beh a v i o r .
Wor k i ng c a p i ta l a c cou n t s i n s u rp l u s p o s i t i on a n d u n u s e d debt
capac i ty a re t h e two mo s t wi de l y u s e d fo rms o f s l a c k .
B.
Ra t i o n a l e for Ho l d i ng Sl a c k
Key n e s ( 1 936 ) s u g g e s te d t h re e mot i v e s f o r ho l d i n g l i q u i d
bal ances .
The t ra n s a c t i o n mot i ve ref l e c t s t h e need for c a s h to
mee t payme n t s for the fa ctors o f p ro d u c t i on , i . e . , payme n t s
a r i s i n g i n t h e o r d i n a ry c o u rse o f bu s i n e s s o r be c a u s e o f the n a t u re
of t h e f i rm 1 S o pe ra t i ng cyc l e .
The p re c aut i o n a ry mot i v e refe r s to
the ma i n te n a n ce o f a cu s h i o n o r bu ffe r l i qu i d ba l a n c e wh i c h can
be u se d i n order to mee t u ne x pected c o n t i ngenc i e s .
F i na l l y , t h e
9
The conventional
structure of
the balance sheet.
/
ff
Working Capital
L iabilities
Working Capital
Assets
I
/
�
/
Net
Working Capital
lL
/
/
Shareholders'
Equity
Fixed
Assets
The new structure
of the balance
sheet
L
v
/
/}"'
/
Slack
�
/
/
Required
Working Capital
Assets
Required
Working Capital
L iabi 1 ities
l.L
/
/
�
)'
Shareholders'
Equity
Fixed
Assets
Figure 1.
v
The Bdlunc� Sheet �edefined
I
10
s pe c u l a t i ve mo t i v e i n corporates t h e no t i o n o f h o l d i n g c a s h i n order
to ta ke a d v a n ta g e o f ex pecte d o p portu n i t i e s i n t h e c a p i ta l ma r ke t .
The o bj e c t i ve h e re i s to s e c u re p ro f i t s by bei n g more knowl edge a b l e
t h a n t h e ma r ke t a b o u t what the fu t u re wi l l bri n g .
Accord i n g to our d e f i n i t i o n , f i rms c a n n o t ho l d s l a c k for
tra n s a c t i o n purpo s e s .
The dema n d o f s l a c k i s not ba s e d o n the de s i re
for a g o o d s h ort-term syn c h ron i z a t i o n o f d i ffe ren t f l ows of rev e n u e s
a n d e x pe n s e s .
Sl a c k cannot be c o n c e i v e d a s an i mportant re s i du a l
wh i c h c a n b e a n a l y z e d i n t h e a rea o f c a s h ma na geme n t .
Howe v e r , there
i s a wi s h on the part of ma n a g eme n t to ma i n ta i n a s a t i s fa c t o ry
bu ffe r l e ve l o f f u n d s wh i c h c a n be s e e n a s a n e l eme n t o f the pre c a u
t i o n a ry o r s pe c u l a t i ve dema n d fo r l i qu i d i ty .
M a n a g e r s wa n t to ma i n ta i n a bu ffe r l e v e l o f l i qu i d i ty i n a n
a ttempt t o red u c e c o s t l y a symmetri c i n fo rma t i o n p ro b l ems t h a t re s u l t
from t h e i s s ue o f new s e c u r i t i e s .
A l t h o u g h the f i n a n c i n g o f a
p ro j e c t a p pears to be a s t ra i g ht fo rwa rd proc e s s , fu n dame n t a l c h a n g e s
i n the e c o n omi c e n v i ronment a n d c o n s e q u e n t t ra n s fo rma t i o n s i n t h e
c a p i ta l ma rkets h a v e comp l i cated corporate f i n a n c i n g a r ra n geme n t s .
L o n g - te rm fu n d s h a v e often been e i t h e r u n a v a i l a b l e o r p e rc e i ved to
be p ro h i b i t i ve l y e x p e n s i v e .
P a r t i a l l y s egme n te d c a p i ta l ma r kets
a n d the ex i s te n c e o f some ma r ke t i mpe rfec t i o n s h a v e made i t
i n crea s i n g l y d i ffi c u l t for c o r po ra t i o n s to s e l l l o n g - t e rm f i xed
rate de bt and e q u i ty s e c u r i t i e s a t p r i c e s t h a t a re fa i r to c u rren t
s h a re ho l de r s .
An i n tere s t i n g s i tu a t i o n a r i s e s when ma n a g e r s , who pos s e s s
c o n f i d e n t i a l i n fo rma t i o n a b o u t new i n v e s tme n t s , dec i de t o i s s u e
11
r i s ky c l a i ms to f i n a n ce new p ro j e c ts .
obj e c t i v e s s hou l d be re c o n c i l e d .
I n t h i s c a s e , two c o n f l i c t i ng
F i rs t , ma n a g e r s s h ou l d p r e s e rve
t he re l a t i ve a d v a n tage wh i c h i s de r i v e d from the i mp l eme n ta t i on of
the new p ro j e c ts as l ong as p o s s i b l e .
Th i s can be a c h i e v e d on l y
when i mportant i n fo rma t i on rema i n s c o n f i den t i a l .
Se con d , ma n a g e r s
s hou l d max i m i ze s ha r e ho l ders ' wea l t h o r the f i rm ' s ma rket va l ue .
Thi s i mp l i e s t h a t i n forma t i o n re l ev a n t to the s u pe r i o r i ty of the
new p roj e c t s s h ou l d be re vea l ed to the ma rket a n d , c o n s e q u e n t l y ,
to c ompet i to r s .
I n a n n o n - c ompe t i t i ve e n v i ronme n t , convey i n g i n fo rma t i on to
the ma rket p l a c e a b o u t new p rofi t a b l e o p portu n i t i e s i s i n the be s t
i n tere s t o f c u rrent s ha re h o l d e r s a n d ma nage r s .
Howe v e r , i n the
pre s e n ce o f compe t i t i o n the re v e l a t i on o f c o n f i dent i a l i n fo rma t i on
bec ome s a c omp l i ca te d p ropo s i t i o n .
A p o s s i b l e s o l u t i on to t h i s
p ro b l em s u g g e s t s t h a t ma n a g e r s c a n s i mp l y a n n o u n ce the e x i s te n c e
of p roj e c t s t h a t c re a te re n t s .
Howe ve r , t h i s me t h o d of c ommu n i c a
t i o n d o e s n o t e l i m i na te the p o s s i b i l i ty o f mo ra l h a z a rd , i . e . , t h a t
t h e i n fo rma t i o n g i v e n i s u n re l i a b l e .
The refo re , fi rms u n a b l e t o
revea l a l l the i n fo rma t i on to the ma rket f o r re a s o n s o f c ompe t i t i v e
a d v a n t a g e wi l l perce i ve t h a t t h e i r c l a i ms a re u n derva l u e d by
i nvestors .
We c a n reco n c i l e the a b o v e s ta teme n t s by s u g g e s t i n g t h a t
s l a c k h a s t h e potenti a l c a p a b i l i ty of pro v i d i n g the f i rm a mec h a n i sm
t h ro u g h wh i c h i t can c ommu n i c a te re l ev a n t i n fo rma t i o n to t h e ma r ke t
i n a v e r i f i a b l e way .
A t t h e s ame t i me , t h i s mec ha n i sm a l l ows t h e
12
fi rm to ma i n ta i n s ome c o n f i den t i a l i ty re g a rd i n g new i n v e s tments .
I t s houl d be noted that the a b i l i ty o f s l a c k to pe rfo rm such a fun c
t i on d e pe n d s upo n s e vera l o t h e r c o n d i t i o n s .
I f t h e s e c o n d i t i on s
h o l d , t h e n i t c a n b e s a i d t h a t t h e ma rket i s a b l e t o i n v e rt the
ma n a ge r i a l dec i s i o n -ma k i ng p roce s s and can i n te rp re t i t s un d e rl y i n g
c h a ra c te r i s t i c s from t h e c h o s e n f i n a n c i a l p a c k a g e o f the f i rm .
The refore , ma nagers o f s l a c k r i c h fi rms woul d b e a b l e t o t a ke
a d v a n t a g e o f unfore seen i n v e s tme nt o p p o rtun i t i e s wi t h out b e i ng
o b l i g a t e d to re vea l confi de n t i a l i n fo rma t i o n .
A l terna t i ve l y , i f
t he c ompany do e s not have a re s e r v o i r o f l i qui d i ty , e i t h e r ex t ra
c o s t s wi l l occur , o r the f i rm fo rgoe s the re a l i z a t i o n o f p rofi ts .
Th i s i mp l i e s that i n s ome c a s e s a fi rm wi t h out s l a c k pas s e s
u p v a l ua b l e i n ve s tme nt oppo rtun i t i e s , i . e . , o p p o rtun i t i e s wh i c h
coul d ma ke a po s i t i ve net c o ntr i but i o n to t h e ma rket va l ue o f the
f i rm .
I f a sudden need fo r fun d s a r i s e s , t he fi rm wi l l h a v e to
g a t he r f i n a n c i ng qui c k l y at a suppl ementa ry c o s t due to the l a c k
o f p re p a ra t i o n o r a bad e c o n omi c e n v i ronment .
Suc h a subopt i ma l
i n v e s tme n t p o l i cy i s a n a g e n cy c o s t i n duced by the unava i l a b i l i ty
of s l a c k .
C.
L i tera ture Re v i ew
Re s e a r c h i n the a rea o f F i n a n c e t rea t s exce s s l i qui d i ty s o l e l y
a s a comp o n e n t o f wo r k i n g c a p i ta l .
The c o s t o f ma i n ta i n i n g a l e ve l
o f l i qui d i ty s tems from the fact t h a t the borrow i n g rate to fi n a n ce
wo r k i n g c a p i ta l a s s ets e x c e e d s the l e n d i ng rate .
Under these
13
c i rcums ta n ce s , t h e re i s a t rade -off be tween the bene f i t s a s s o c i a ted
wi t h l i q u i d i ty a n d the costs o f ma i n ta i n i ng i t .
Mo s t of t h e wo r k
i n t h i s a re a h a s b e e n d i rected towa rds o p t i m i z i n g the l e v e l s of c a s h
a n d ma rketa b l e s e c u ri t i e s , s o t h a t t h e f i rm doe s n o t c a rry a ny
exc e s s u n de s i ra b l e l i qu i d r e s o u r c e s .
However , the o pt i m i z a t i on
p ro c e s s i s c o n s i dered myo p i c for t h e fo l l owi n g t h re e rea s o n s .
F i rs t ,
the p ro c e s s i s i n comp l ete i s o l a t i o n wi t h regard to t h e o pt i mi z a t i on
o f o t h e r a s s e t s , a n d mo re i mporta n t l y , from t h e o v e ra l l v a l u a t i o n
o f t h e f i rm .
Se co n d , mo s t o f the work h a s t rea ted c u rre n t a s s et s
a n d fi x e d a s s e t s s e pa ra te l y .
T h i s s p l i t i s u n fo rt u n a te a n d ten d s
t o foc u s a tt e n t i o n on o n l y one p a rt of t h e ba l a n c e s he e t wi t h o u t
c o n s i de r i ng t h e f i rm ' s o v e ra l l v a l u a t i o n i n a compe t i t i ve e n v i ronme n t .
Th i rd , v a r i o u s components of wo r k i n g c a p i ta l , a n d i n p a rt i c u l a r c a s h ,
h a v e been d i vorced from the mo s t fun dame n t a l de c i s i o n s of i n ve s tme nt
a n d fi n a n c i ng .
I n a d d i t i o n to t h e prev i o u s l y me n t i oned re a s o n s , mo d e rn
fi n a n c i a l theory , u n t i l rec e n t l y , comp l e te l y i g n o re s l i q u i d i ty .
The
two t ra d i t i o n a l mode l s , CAPM a nd APT , by con s tru c t i o n a re not a b l e
to v a l ue l i q u i d i ty .
In a wo r l d o f r i s k l e s s borrow i n g a n d l en d i n g
the re i s no re a s o n f o r t h e f i rm t o c a r ry a s t o c k o f c a s h a n d ,
c o n s e q u en t l y , i tems of wo r k i n g c a p i t a l a re u n n e c e s s a ry a n d i rre l ev a n t
t o t h e f i rm ' s v a l u a t i on .
F u rt h e r , t h e degre e of l i q u i d i ty i s a
ma tter of i n d i ffe rence to e q u i ty ho l de r s .
I f the re a re pe rfect
c a p i t a l ma rkets i n v e s to r s c a n ma ke d i ve rs i f i c a t i o n dec i s i on s by
c re a t i ng t he i r own homemade l everage , i n s u c h a way a s to s a t i s fy
14
the i r u t i l i ty for l i qu i d fu n d s .
F o r a g i ven i n v e s tme n t s t ra tegy ,
l i q u i d i ty i s i rre l e v a n t to s h a re ho l d e r s .
De s p i te the a bove-me n t i o n e d a rg ume nts a b o u t the i rre l e v a n c e
of s l a c k , t h e re a re a few s tu d i e s t h a t h a v e a d d re s s e d t h e re l a t i o n s h i p
o f ( ex ce s s ) l i q u i d i ty a n d o t he r f i n a nc i a l v a r i a b l e s .
Essenti al l y ,
t h e re a r e t h ree g ro u ps o f s tu d i e s t h a t a d d re s s the fo l l ow i n g
re l a t i o n s h i p s :
(a)
L i q u i d i ty a n d debt l e v e l ,
(b)
L i q u i d i ty a n d c o n f l i c t re s o l u t i on o f d i ffe re n t g rou p s
o f s h a r e ho l d e r s , a n d
(c)
L i qu i d i ty a n d t h e p ro b l em o f ma rket v a l u e dec l i ne a t
t he a n nounceme n t o f e x t e rn a l fi n a n c i n g .
L i q u i d i ty a n d De bt L e v e l
Do n a l d s o n ( 1 969 , 1 9 7 1 ) a rg u e s t h a t the f i rm wi l l h o l d l i q u i d
re s o u rc e s i n a n a ttempt to a v o i d ba n kru ptcy d u r i n g t i me s o f fi n a n c i a l
c ri s e s .
M a n a g e r s wi l l u s e l es s debt t h a n a n t i c i pated beca u s e t h ey
wa n t to ma i n ta i n a c u s h i o n o f u n u s e d funds t h a t c a n be u s e d on a
p re ca u t i on a ry pu rpo s e .
Thi s c u s h i on g i v e s the f i rm s ome f i n a n c i al
mo b i l i ty wi t h wh i c h i t c a n s u rv i ve the c r i s i s .
Dona l d s o n d i d not
a d d re s s t he i s s ue a s to what i s t h e a p pro pri a te l ev e l o f l i q u i d
a s se t s t h a t a v alue ma x i m i z i n g e n t i ty s houl d h o l d .
Mod i g l i a n i a n d
M i l l e r ( 1963 ) recogn i z e d t h e n e e d f o r f l ex i b i l i ty b u t a s s umed t h a t
i t wou l d c ome from u nused debt c a pa c i ty rather t h a n l i q u i d a s se t s .
B i e rma n a n d Thoma s ( 19 7 2 ) a ttempted to f i n d t h e o p t i mum
amo u n g o f debt t h a t the f i rm s h ou l d h o l d i n o rd e r to ma x i m i z e t h e
- - - --
-----
15
re t u r n s to s to c k h o l ders .
I n a n exten s i o n o f t h i s wo rk , B i e rman ,
Chorpa a n d Th oma s ( 1973 ) i n troduced wo r k i ng c a p i ta l a s a bu ffe r
dev i c e a g a i n s t b a n k ru ptcy .
Ag a i n , t h ey fou n d the o p t i ma l amo u n t
o f debt f o r the fi rm t o h o l d , s u c h t h a t the retu rn to s to c k h o l ders
i s opti mi zed .
L i qu i d i ty a n d Age n cy P ro b l ems
Ka l ay ( 1982 ) , a d d re s s i ng a d i ffe re nt t o p i c , i n an a t tempt
to re s o l ve the wea l t h t ra n s fe r p ro b l ems that ex i s t among s h a re h o l ders
and bo n d h o l d e r s ,
l oo ke d at the d i rect a n d i n d i rect c o n s tra i n ts
i mp o s e d o n d i v i de n d payme n t s .
For a c ompa ny w i t h a l i mi te d s u p p l y
o f p o s i t i v e N PV p roj ec t s , a commi tme n t t o pay d i v i d e n d s by ma i n
t a i n i n g s ome re s e rv o i r o f fu n d s i s fa r more p refere n t i a l t h an the
c a s e where t h e f i rm i s i n v o l v e d i n ove r i n ve s t i n g ( i . e . , a c c e pt i n g
p roj e c t s w i t h neg a t i ve N PV ) .
I n t h i s s e tt i n g a reservo i r o f l i q u i d
funds red u c e s the l i ke l i h ood o f o v e r i n v e s t i n g a n d e l i m i n a te s the
c o n f l i c ts o f i n te re s t amo ng s to c k h o l d e r s a n d b o n d h o l de r s as they
were d e s c r i bed i n the J e n s e n a n d Me c k l i n g ( 19 76 ) framewo r k .
Ka l ay's
emp i r i c a l work u n c o v e rs the s u rp r i s i ng re s u l t t h a t f i rms h o l d po s i
t i ve re s e rv o i rs whose mag n i t u d e s a re n o n - t r i v i a l for p e r i o d s of more
t h a n ten yea rs .
I nd i re c t l y we h a v e e v i dence for t h e s i g n i f i c a n c e
o f s l a c k , a l thou g h the ex p l a na t i o n h e re i s b a s e d o n t h e c o n t ro l o f
c o n f l i c ts among s to c k ho l d e r s a n d b o n d h o l ders .
N e v e rt h e l e s s , the
e x i s t e n c e o f these re s e rvo i r s i s j u s t i f i e d on a cost ba s i s ; i t i s
more e x pe n s i v e for ma nagers to o v e r i n v e s t a n d pay n o d i v i de n d , t h a n
t o keep s l a c k wi t h the i n te n t i on o f pay i ng s ome futu re d i v i de n d s .
16
S l a c k a n d Annou ncements of Exte rna l F i n a n c i ng
I n t h i s s e c ti o n we p re s e n t s ome papers wh i c h a re re l a te d to
o u r re s e a rc h e ffort .
I n t h e proce s s o f de s c r i b i ng t h e maj o r cont r i
bu t i o n s o f t h e s e papers , we a l so c r i t i c i ze s ome of the a s s umpti o n s
o f the mode l s p re s e n ted .
H u b e rma n ( 1 984) deve l o pe d a t h e o ry , name l y the l i q u i d i ty
theory , t h a t e x p l a i n s the o b s e rv e d n e g a t i ve c o r re l a t i o n between t h e
ma r ke t v a l u e o f the f i rm a n d i t s e x t e rn a l f i n a n c i ng a c t i v i ty .
Hi s
theory i s s i mi l a r to the Keyne s i a n theory o f mo n ey dem a n d f o r
s pe c u l a t i ve pu rposes .
L i q u i d i ty i s d e f i ned a s t h e ca s h a va i l a b i l i ty
wh i ch i s de r i v e d f rom the need to h a v e funds before t h e i nv e s tment
o p p o rtu n i ty a r i s e s .
There a re two maj o r s o u rces of l i qu i di ty,
( a) c u r r e n t ca s h f l ows , that i s , reta i ne d e a rn i n g s , a n d ( b ) exte rn a l
debt f i n a n c i ng .
The co s t o f h o l d i n g l i qu i di ty i s e x p l a i ned on the
bas i s o f e i t h e r tax l i a b i l i t i e s o r a g e n cy co n s i de ra t i o n s .
To mea s u re
th i s c os t , i t was a s s umed t h a t l i qu i d funds a re r i s k l e s s a s sets t h a t
h a v e retu rns l ower t h a n t h e r i s k - free rate .
H u b e rman de v e l oped a
dynami c prog ramm i ng p rob l em wh i c h co n s i ders the c o n t i n u o u s i nter
a c t i o n among the f i rm ' s i n v es tment opportu n i t i e s , i ts l i qu i d po s i t i o n ,
a n d i ts c a s h f l ows ( ea rn i n g s ) .
I t was proven t h a t t he i n v e s tme nts
on l i q u i d a s s e t s we re re l a t e d to the a n t i c i p a ted c a s h f l ows .
It
shou l d be noted t h a t the mo d e l i s b a s e d o n t h e a s sump t i o n s that
i n v e s tme n t o ppo rtu n i t i e s a re certa i n and that on l y futu re e a rn i n g s
a re u n c e r ta i n , a l though some o f t h i s u n c e rta i nty i s re s o l ved e x - a n t e .
-�-�---- ---- ---- -------
17
Hube rma n ' s mode l h a s a n i n tu i t i ve a p p ea l , s i nce h i s re s u l t s confi rm
the n e g a t i ve corre l a t i on betwee n t h e f i rm's v a l u e a n d e x t e r n a l
fi nanc i ng .
H u b e rma n c l a i ms that h i s t h e o ry i s ba s e d o n a rg u me n t s o f
l i q u i d i ty.
Howeve r , i t i s v e ry d i ff i c u l t to see t h a t h i s a n a l y s i s
i s s t ru c tu re d exc l u s i ve l y a ro u n d l i q u i d i ty a r g ument s .
For examp l e ,
the c o s t o f c a s h a va i l a b i l i ty c a n be j u s t i f i e d on a s s umpt i o n s o f
a symme t r i c i n fo rma t i o n w h i c h l ea d s to the a g e n cy p ro b l em a n d ,
the re fo re , to the c o nc l u s i on s c i ted by Hube rma n .
A n o t h e r l i mi tati o n
o f t h e a n a l y s i s i s t h e n o n - s t o c h a s t i c n a ture o f t h e i nv e s tmen t
dec i s i on s wh i ch d ra s t i c a l l y s i mp l i f i e s i s s u e s o f l i q u i d i ty man age
men t .
In a d d i t i o n , the conj e c tu re o f t h e r i s k - f re e debt e l i mi n a t e s
poten t i a l , a l t h o u g h comp l ex , s i g n a l i ng p ro b l ems .
De s p i te the a bo v e
me n t i o n e d mi n o r l i mi ta t i o n s , H u be rman's ana l ys i s c o n v ey s a s tro n g
me s sa g e :
t h e f i rm ' s va l ue , i t s l i qu i d i ty po s i t i on , a n d t h e i nv e s t
ment dec i s i on a re i n terre l a ted.
The mo s t re l e v a n t wor k i n the a re a o f the i mportance of s l a c k
i s t h e mo d e l o f Mye r s a n d Maj l u f ( 1 984 ) .
U s i ng n umer i ca l a n a l y s i s
tec h n i q u e s , they p ro v e d t h a t i n a wo r l d o f a symme t r i c i nfo rmat i o n ,
mana g e r s c a n rej e c t profi ta b l e i n v e s tme n t o p portu n i t i e s w i t h out
red u c i n g c u r re n t s h a re h o l d e rs ' wea l th .
Th i s pa radox i ca l a c t i on c a n
be e l i m i n a te d o n l y when ma n a g e r s h a v e a c c umu l a ted s l ac k re s o u rc e s
before t h e i n v e s tmen t o ppo rtu n i ty a p pe a r s .
Cl e a rl y , t h e Myers a n d
Majl u f a na l ys i s co n s i ders the i nt e ra c t i on o f t h e f i n a n c i n g a n d
i n v e s tme n t d e c i s i o n .
A s i mu l t a n e o u s a n noun c emen t o f i nv e s t i n g /
18
f i n a n c i ng o f a p roj ect commu n i c a t e s u n fa vorab l e n e w s to o u t s i d e r s
w h o v i ew t h e dec i s i o n to i s s u e n ew s h a re s a s a d i l u t i on o f t he i r
own e r s h i p o f e a rn i n g s.
Even when debt c l a i ms a re i s s u e d , the re s u l t
o f the dec l i ne i n the f i rm's ma rket va l u e i s obta i ne d .
The cen tra l
cause o f t h e p ro b l em i s t h e a symme t ry o f i n fo rma t i on regard i ng t h e
va l u e o f a rea l o pt i on t h a t ex i s t s be tween ma n a g e r s a n d s h a rehnl ders .
The Mye rs a n d Maj l u f ( 1 984 ) a n a l y s i s c l e a r l y s h ows t h e v a l u e
o f s l a c k i n a n a symmetri c i n fo rma t i o n worl d .
Th i s resu l t wa s obta i n e d
on t h e a s s umpti o n t h a t t h e re a re not c o s ts o f ho l d i n g s l a c k .
I mp l i c i t l y i t wa s conj e c tu re d t h a t t h e o p t i mum l ev e l o f s l a c k i s
u n l i mi te d (in f i n i te ) .
That i s , the a u t h o r s a do pted a ra t h e r unrea l
i s t i c c o r n e r s o l u t i o n wi thou t bound a s to t h e u t i l i z a t i o n o f s l a c k .
Howe v e r , a s H u be rma n ( 1 984 ) a n d o t h e r s have i n d i c a t e d , t h e re a re
c o s t s a s s o c i ated wi t h the ma i n te n a n ce o f s l a c k .
Therefore , a c omp l ete
a n a l ys i s o f the v a l ue o f s l a c k s h ou l d i n co rporate both t h e c o s t s
a n d be n e f i t s d e r i v e d by ho l d i n g s l a c k .
I n a d d i t i o n , the Mye rs a n d Maj l u f ( 1 984 ) mo d e l a d d re s s e s i n
a re s t r i c t i ve way the i n v e s tme nt o p po rtu n i ty .
I t i s a s s u me d t h a t
an i n v e s tme n t o p po rtun i ty req u i re s a predetermi ned amo u n t o f ca p i ta l .
The i n ve s tme n t oppo rtun i ty h a s the " ta ke i t o r l e ave i t " fea ture .
Howe ve r , t h e re a re p roj e c t s i n wh i c h ma n a gement c a n i n v e s t v a r i a b l e
amou n t s o f c a p i ta l .
Cl e a r l y , t h e Mye rs a n d Maj l uf ( 1 9 84 ) mode l wa s not d e s i g n e d
wi t h the i n ten t i on t o a n swe r the a b o v e s ta te d p ro b l ems .
Ou r purpose
here i s to demo n s t ra te t h a t e v e n after ma k i n g a l l owa n c e s for more
19
rea l i s t i c as s umpt i o n s , such as t h e cost o f ho l d i ng s l a c k , t h e Mye r s
a n d Majl u f framewo r k prov i de s a r i c h e n v i ronme n t i n a n a l yz i ng
fi nan c i a l
de c i s i on s u n d e r a symme t r i c i n forma t i o n .
I n t h i s es say we deve l o p a mod e l t h a t e x l i c i t l y t a k e s i n to
a c c o u n t the c o s ts and bene f i t s o f h o l d i ng s l a c k.
I n order to a n a l yze
the v a l u e o f s l ac k we u se d a framewo rk wh i ch i s s i m i l a r to Mye r s
a n d Majl u f ( 1 984 ) .
W e c ho o se t o i mpose a c o s t s t ru c tu re fo r h o l d i ng
s l a c k t h a t i s conceptua l l y s i m i l a r to the c o s t o f l i qu i d i ty de ve l oped
by Hube rman ( 1 984 ) .
It i s conje c t u red t h a t s l a c k a ri s e s i n res p o n s e
t o o rgan i za t i o n a l a n d e n v i ronme n t a l p r o b l ems a n d i t c a n o c c u r i n
e x - p o s t e ffi c i e n t organ i za t i o n a l forms , de s p i te t h e p re s e n c e o f
a symme t r i c i n fo rma t i o n a n d mo ra l haza rd .
Ou r mod e l i n t roduces a
v a l u a t i on m e c h a n i sm tha t c l ea r l y recogn i ze s the l i m i ta t i o n s of
extern a l bo r row i ng .
I n the fo rmu l a t i o n of t h e p ro b l em we a t tempt
to re l ate t ra de o ff e ffects of e x te r n a l fi nan c i ng w i t h the v a l ue
of growt h opportu n i ty .
F i na l l y , o u r a n a l y s i s a c c e p t s the no t i on
t h a t i nv e s tmen t i n grow t h o p t i on i s a c o n t i n u o u s v a r i a b l e .
III.
A.
MOD E L CON S I D E RATI ONS
Majo r A s s umpt i o n s
(A. 1 )
The re i s one p e r i o d framewo r k w i t h two d a t e s 0 , 1 .
(A. 2)
The e c o n omy i s popu l a ted by ma nage r s ( w ho ma ke i n v e s tme n t
f i n a n c i ng de c i s i o n s ) , a n d s h a re h o l d e rs ( w ho own the stoc k
of the f i rm ) .
20
(A. 3)
T h e re i s a symmet ry o f i n fo rma t i on betwee n ma n a g e r s a n d
c a p i ta l ma rkets re g a rd i ng the q u a l i ty of the i n v e s tme nt
de c i s i o n .
Managers h o l d s u pe r i o r i n fo rma t i o n re g a rd i n g
i n v e s tme n t a l terna t i v e s a n d o t h e r f i n a n c i a l d a ta .
If
managers i de n t i fy a n i n v e s tme n t opportu n i ty t h a t c reates
an i n te rtempora l a d v a n ta g e o v e r compe t i tors , t hey a re
con fronted wi t h two c o n f l i c t i ng obj e c t i v e s :
( a ) To
pre s e rve the re l a t i ve a dv a ntage a s l on g as po s s i b l e .
Thi s
c a n be a c h i eved o n l y when i mportant i n fo rma t i o n rema i n s
c o n f i den t i al .
( b ) The ma n a g eme nt s h ou l d max i m i z e s h are
h o l ders • wea l t h o r t h e f i rm • s ma rket va l u e .
Managers
s hou l d re v e a l to the ma rket deta i l s a b o u t t h e n a t u re o f
profi ta b l e opportu n i t i e s .
The n , ma rket parti c i p a n t s wi l l
re s po n d to the new i n fo rma t i o n by buy i ng o r s e l l i n g fi rm • s
securi ties .
I n a c ompeti t i ve e n v i ronme n t the ex i s te n c e
o f c o n f l i c t i ng a l tern a t i v e s ( a ) a n d ( b ) ma kes the reve l a
t i on o f c o n f i d e n t i a l i n fo rma t i on a c omp l i ca t e d propos i t i o n .
(A. 4)
The re a re two k i n d s o f i n v e s tme nt .
I n v e s tme n t i n a s s e t s
i n p l a c e ( I * ) a n d i n v e s tme n t i n g rowth op t i o n s ( I - I * ) .
A s s e t s i n p l ace re pre s e n t c u rrent opera t i ng req u i reme n t s
w h o s e ma i n te n a n c e req u i res a n I n v e s tme n t I * .
The f i rm
determ i nes the l e v e l o f I * by u s i ng the N PV ru l e .
i n v e s tme nt i n g rowth o pt i o n s ( I - I * ) i s a c on t i n u o u s
v a r i a b l e w h i ch i s p a r t i a l l y determi n e d by t h e s l a c k
a v a i l a b i l i ty .
The
------- -----
21
(A. 5 )
The v a l u e o f the a s s e t s i n p l a c e i s determi n e d by the f u n c
t i on f ( I ) .
I t i s a s s ume d t h a t the fu n c t i o n f ( I ) h a s the
c l a s s i c a l prope rt i e s f 1 ( I )
>
0
a n d f11 ( I )
2
a co n t i n u o u s a n d d i ffe re n t i a b l e func t i o n .
a pos i t i ve , howe v e r sma l l .
0
,
and i t i s
f ( I ) i s a l way s
The va l ue of the g rowth
o p t i o n i s dete rmi n e d by t he f u n c t i o n g ( I - I * ) wh i c h i s ,
w i t h o u t l o s s of g e n e ra l i ty , a n i n c re a s i ng fun c t i o n wi t h
re s p e c t to the i n v e s tme nt i n the g rowt h o p t i on , ( I - I * ) ,
w i th a d e c rea s i ng rate , t h a t i s , g 1 ( . )
>
0
a n d g 1 1 ( . ) _2
0.
I t i s further a s s u me d t h a t g ( . ) i s a co n t i n u o u s a n d d i ffere n t i a b l e func t i o n .
(A. 6 )
The v a l u e o f the f i rm i s g i ven by the fo l l ow i n g func t i o n :
V
=
f(I * )
+
(1)
g ( I - I*) - p (I - I * , s )
whe re :
I*
i s t h e a c t u a l l e v e l of i n v e s tme n t i n
a s s e t s i n p l ace ,
I-I*
amo u n t of i n ve s tme n t i n the g rowth
o p portu n i ty ,
p (I - I * , s )
i s a f u n c t i o n i nd i ca t i n g a 11 pena l ty 11 t h a t
o u t s i de r s a s s i g n a g a i n s t the f i rm 1 S v a l u e
a s a re s u l t of t h e a symme t ry o f i n forma ti on .
I t i s a s s ume d th a t :
ap ( I - I * , s )
as
and
<
0
ap ( I - I * , s)
aI
( 1. 1)
>
0
( 1 .2)
22
The ra nge of the p ( . ) funct i on cons i s ts o f
n o n - ne g at i ve numbers.
A l s o the a rguments
o f the p ( . ) fun c t i o n s a t i s fy the con d i t i on
(1 .3)
Fu rthe r i t i s a s sume d t h a t
f( . ) . g( . )
82p(l-l*,sl
:::o
at as
( 1 .4)
v a l u a t i on f u n ct i o n s of the a ss e t s i n p l a c e
a n d g rowt h o p t i o n s , re s pe c t i v e l y.
F i g u re 2 represents i n a d i a g ramma t i c a l
form t h e re l a t i o ns h i p between i nv e s tmen t
l ev e l a n d t h e f i rm ' s v a l ue .
We d raw the
f u n c t i o n s f ( . ) a n d g ( . ) a s c o n t i nuou s
i nc rea s i n g func t i o n s w i t h a dec re a s i n g
ra te .
( A.7 )
At the beg i n n i ng o f t h e per i od , t h e f i rm h a s s l a c k s.
Ca r ry i n g s l a c k i s cos t l y.
I f the c o s t o f cap i ta l i s w , t h e
o pp o r tu n i ty c o s t fo r h o l d i n g s l a c k i s w*s.
B.
Di s cu s s i o n
Managers i n antic i pat i on o f c u r re nt needs to s u pport the
opera t i on of the a s set s i n p l a c e choose a l ev e l of I nv e s tmen t I*.
Th i s e x - a n te l e v e l of i n v e s tme n t , wh i c h i s the re s u l t o f the p ro d u c t
dema n d a n d t h e compe t i t i ve ma r ket c o n d i t i o n s , represen t s opera t i n g
req u i remen t s a n d a n t i c i pated c h a nges i n ex i s ting rea l a s s e t s .
If
a n i nv e s tmen t o p po rtuni ty a p pea rs i n the h o r i z o n , ma n a g e rs may c h o o s e
to a ugme n t th i s e x - a n te i nv e s tmen t l e v e l , a fte r rec e i v i ng s ome
a s s e s s men t s o f cu r re n t c a s h - f l ows a n d g rowth o p p o r t u n i t i e s , by
a s k i n g for more ca p i ta l .
Howev e r , ma n a gers a re u na b l e t o commu n i c a te
23
The Firm's
Value
p (I'-I*,O)
p(l-I*,s)
f
g(I-I*)
F
1
I
I
-l---
I
T
f(I*)
I
I
II
l
I*
I'
Increased investment is
a function of slack
I': Level of investment without slack
I : Level of investment with slack
I+: Optimum level of investment without penalty
p (I-l*,s}: The penalty function
A,B: Loss in value due to penalty
F : Market Value gains due to the availability of slack
Figure 2.
Investment Level and the Value of Slack
I+
Investment in
Growth
Opportunity
24
the t ru e �u a l i ty o f the i n v e s tme n t o p p o rtu n i ty to o u t s i d e r s for a
n umbe r o f re a s o n s .
Fi rs t , i n fo rma t i on a bo u t n ew i n v e s tments ha s
p ro p r i e t a ry v a l ue .
I n a n i mpe rfec t l y compet i t i ve ma r k e t a n a n n o u n ce-
men t of a g o o d i nv e s tme n t p roj e c t a tt ra c t s new compe t i tors who
s ub s ta n t i a l l y redu ce the ren t s g e n e ra te d by t h i s o p p o r tu n i ty .
A
s e c o n d a n d comp l i mentary rea s o n i s t h a t ma n a g e r s a re c o n c e rn e d w i t h
t h e a pp r o p r i a b i l i ty a n d prote c t i o n o f retu rn s a s s o c i a te d w i t h t h e
s u pe r i o r i n fo rma t i o n they h o l d .
A n o pe n d i s c l o s u re o f i n fo rma t i o n
a bo u t t h e c h a ra c te r i s ti c s of t h e p roj e c t e n da n ge r s t h e f i rm•s a b i l i ty
to d e r i v e l on g-te rm ri s k a d j u s te d re tu rn s .
W h i l e t h e ma n agers d i l emma i s we l l recogn i ze d a n d u nd e rs to o d ,
i t d o e s i mpos e s ome pro b l ems o n the s u p p l i e rs o f c a p i ta l .
S i nce
o ut s i d e r s po s s e s s i mperfe c t know l e d g e about t h e new proj e c t , they
a re not a b l e to a s s e s s wi t h c e rta i n ty t h e i r mod i f i e d oppo rt u n i ty
set .
A s H i rs h l e i fe r ( 1 9 7 3 ) poi n t e d o u t , i n d i v i du a l s be i ng i n t h i s
po s i t i o n a re s u bj ec t to t e c h no l og i ca l u nc e rta i n ty i n t h e s e n se t h a t
they a re u n s u re a b o u t t h e i r res o u rc e endowme n t s a n d p ro du c t i ve
o ppo rtun i t i e s .
Moreove r , o u t s i d e r s rea so n that m a n a g e r s ma x i mi z i n g
cu rre n t s h a re h o l ders we a l th w i l l b e re l u c ta n t to ta ke any a c t i o n
wh i ch t ra n s fe r s wea l th t o a n o u t s i de c o n s t i t u e n cy.
N e e d fo r extern a l
f i n a n c i ng i s perce i ve d a s a n a c t i o n t h a t exp l o i t s new s h a re ho l de rs •
wea l th i n fa v o r o f c u rrent s ha re h o l d e r s ( My e r s a n d Maj l u f ( 1 984 ) ) .
I n s umma ry , the fo l l owi n g p l a u s i b l e c o n d i t i o n s fo rce c a p i ta l
ma rket pa rt i c i p a n t s to a s s i g n a pen a l ty fu n c t i o n to the f i rm 1 S
val ue :
( a ) ma n a ge r i a l i na b i l i ty to c ommu n i c a te news to o ut s i ders
25
i n a v e r i { i a b l e and c re d i b l e way , for re a s o n s o f c o n f i den t i a l i ty
a n d a p propri a b i l i ty of i n fo rma t i on , ( b ) i mperfect a s s e s sme n t from
o u t s i d e r s of t he i r new opportu n i t i e s due to i n comp l e te i n fo rma t i on ,
a n d ( c) o u t s i de rs� rea s on i ng , s i nce a symme t r i c i n fo rma t i on prev a i l s ,
t h a t the new c a p i t a l wi l l be u s e d a s a ve h i c l e i n p a r t i a l l y exp l oi t i ng
the i r we a l t h .
The refore , the p e n a l ty funct i o n i s j u s t i f i e d on the
bas i s o f a ny o r a l l of the a bo v e a rgume n t s .
A d i ffe rent i n terpre t a t i on, h owe ver, i s p o s s i b l e for the
pena l ty fun c t i o n .
We can a rg u e t h a t the pe n a l ty f u n c t i o n repre s e n t s
a 11premi um11 t h a t c a p i ta l ma rkets a s s i g n t o t h o s e f i rms t h a t wa n t
to p u r c h a s e the maj o r factor o f produ c t i on , t h a t i s , i n ve s tme n t
( c a p i t a l ) i n t h e s p o t ma rket .
Th i s premi um i s c h a rged to t he f i rm
a s a re s u l t o f the a symme t r i c i n fo rma t i on amo n g the part i e s i n v o l ved ,
rather t h a n a s the o u tc ome o f a co s t l y t ra n s a c t i on c o n t ra c t .
I n order to s u bs t a n t i a te o u r a rg ume n t we con s i de r a v a r i a t i on
o f the 111 emo n 11 prob1 em pre se n ted by Akerl of ( 19 7 0 ) .
I n v e s t o rs buy
an i s s u e w i t h o u t knowi n g whe t h e r the i s s u e i s a good o r bad i s s u e .
Man agers, a s s e l l e r s of f i nan c i a l i n s t rume n t s , h a v e more knowl e d g e
c o n c e rn i n g the ri s k c h a ra c te r i s t i c s a n d g e n e ra l l y the q u a l i ty o f
the s e c u r i t i e s o ffere d .
A l l o t h e r t h i n g s bei ng equ a l , g o o d a n d b a d
i s s u e s s h ou l d s e l l a t the s ame pri ce , s i nce i t i s i mpo s s i b l e for
a buye r to t e l l ex- a n te the d i ffe rence between a good a n d a bad i s s u e .
Nev e r t he l e s s , i n v e s to rs l e a rn e x - p o s t a bout 11 l emo n 11 i s s u e s .
Ra t i o n a l
i nv e s to r s , s i nce they 11 l e arn by ma k i ng m i sta kes , 11 d i s co u n t e x - a n t e
pos s i b l e s u bop t i ma l q u a l i ty , when n e w s e c u r i t i e s a re o ffe red i n the
26
c a p i ta l ma rket s .
Wi th o u r f ramewo r k , t h e re i s an o b v i ou s q u a l i ty
u n c e rta i n ty p rob l em wh i c h a r i s e s f rom the a symme t ry of i n fo rma t i o n .
The pe n a l ty fun c t i o n wa s pre s ented w i t h two a rg ume nts :
i n ve s tmen t s i ze ( I - I * ) a n d the s l a c k l e vel s .
the
I t i s a s s u me d t h a t the
l a rge r t h e o u t s i de c a p i ta l re que s te d for f i n a nc i ng , t h e l a rg e r the
a g g re g a t e pen a l ty o n the f i rm ' s va l u e .
I t i s a l so a s s ume d that
fun c t i on p i s i t s e l f a de c rea s i ng func t i o n i n s l a c k .
T h i s a s s umpt i o n
i s ba s e d o n the o b s e rvat i o n t h a t a h i g he r l e ve l o f s l a c k i mp l i e s t h a t
s h a re h o l ders ha ve a greater s t a ke i n t h e growth opportu n i ty ; t h a t i s ,
s h a re h o l de rs own a l a rge pe rce n t o f the proj e c t.
Le l a n d a n d Pyl e
( 1977 ) i mposed a s i mi l a r c o n d i t i on on the p r o b l em o f i n te rme d i a t i on.
A l a rg e s l ac k on a p roj ect by the i n s i de r-ma n a g e r commun i c a te s
fa v o ra b l e news to o u t s i ders who p l a c e a po s i t i v e v a l u e on th i s g rowt h
o ppo rtu n i ty .
S i mi l a r l y , i n o u r framewo r k s ha re h o l ders p e r c e i ve
a ccumu l a te d s l a c k resou rce s as a part of the i r pa r t i c i pa t i o n i n a n
i nv e s tmen t proj ec t .
To the e x t e n t that the re a re n o t c o n f l i c ts o f
i n te re s t s be tween s h a re ho l de r s a n d ma nagers , the l a rge r t h e s l a c k ,
the sma l l e r t h e pena l ty o n the f i rm ' s va l u e .
The a s s umpt i on t h a t
a2p/asai i s n o n - pos i t i ve i s , i n fa c t , the on l y i n teres t i n g c a s e
of a l t e r na t i ve s pe c i fi ca t i o n s of the pena l ty fun c t i o n .
I t i mp l i e s
t h a t the i n v e s tme n t l e v e l i s a n o n - i n c re a s i ng fu n ct i on o f s l ac k
a n d t h a t the ma rg i na l pen a l ty w i t h re s pe c t t o i n v e s tmen t {ap/ai)
i s a d e c rea s i n g fu n c t i o n i n s l a c k .
Ou r mod e l i s co n s i s t e n t wi th the ob s e rved reg u l a r i ty o f s t o c k
pr i c e d e c l i n e w h e n t h e re i s an a n no u nceme n t o f e x te rna l f i na n c i n g .
27
I bbotson ( 1 9 7 5 ) wa s among the f i r s t who docume n te d an u n de rpri c i n g
re g u l a r i ty o f new i s s ue s .
Re c e n t s tu d i e s by A s q u i th a n d Mu l l i n s
( 1 986 ) a n d Ko rwa r ( 1 986 ) o ffe r mo re deta i l e d a n a l ys i s o f the
phenome n o n .
Fi na l l y , Da n n ( 1 9 8 1 ) and Va rma e l en ( 1 9 8 1 ) fo u n d that the
o p po s i te a c t i o n , t h a t i s , the re p u r c h a s e o f the fi rm • s c ommo n s t o c k
re s u l t s i n a pos i t i ve ma rket re a c t i o n .
T h e emp i r i c a l e v i d e n ce
pre se n te d i n t h e s e s tud i e s c l e a r l y demo n s tra te s t h a t a n a n n o u n ceme n t
o f extern a l f i n a n c i ng h a s a nega t i ve i mpact o n t h e f i rm • s v a l ue .
C.
An a l ys i s
W i t h the s e p a ra t i on o f t h e i n v e s tme n t from f i n a n c i n g dec i s i on s
ma n a g e rs a c c e p t o r rej e c t p roj e c t s i n depende n t l y o f t h e way o f
f i n a n c i ng .
Howe ve r , i n a n e n v i ronme n t o f a symme t r i c i n fo rma t i o n
the l a s t s ta teme n t i s not a l ways tru e .
I n p a r t i c u l a r , i n v i ew o f
the pena l ty ru l e ( 1) ma nagers we i g h the be n ef i t s o f a n e w i n v e s t
me n t ( I - I *) a g a i n s t the i n c reme n ta l c o s t s t h a t occ u r to t h e s ha re
hol ders .
T h e bene f i ts o f a n i n v e s tme nt opportun i ty a re s umma r i z e d
i n the g ( I - I * ) term , where a s the c o s t s a re refl e c ted i n t h e pe na l ty
form p ( I-I* , s ) .
T he c o s t s a s s o c i a te d wi t h the i s s u e o f n ew s e c u r i t i e s , i . e . ,
t he pena l ty fu n c t i on , c a n be red u c e d by h o l d i n g s l a c k beca u se t h e re i s
a n i n v e r s e re l a t i o n betwee n pena l ty a n d s l a c k .
S i nce more c a p i ta l
i s i n v e s te d i n the g rowth o p po rtu n i ty , a n a d d i t i ona l ben e f i t i s
rea l i z e d a n d i t i s refl e c ted i n t h e i n c re a s e d va l ue o f the g rowt h
o pportu n i ty g ( I - I * ) .
Certa i n l y , h o l d i ng s l a c k i s a n i n tere s t i n g
28
pro po s i t i o n , bec a u s e of i t s benefi ts , that i s , t h e red u c t i o n of
fo regone prof i ta b l e i n v e s tmen t o p po rtu n i t i e s d u e to pen a l t i e s
a s s oc i a t e d w i t h i s s u i ng s to c k .
Howe ve r , ho l d i n g l a rg e amo u n t s o f
s l a c k i s u nwa rra n te d a n d u n n e c e s s a ry .
Th i s i s true be c a u s e i n
add i t i o n to the c o s t of h o l d i ng s l a c k , i t i s q u i te po s s i b l e that
the i n c reme n t a l i mp roveme n t s on t h e v a l u e of g rowth o p p o rtu n i ty wi l l
not o u twe i g h t h e i n c reme n t a l c o s t s a s s o c i ated wi t h the pena l ty , p ,
wh i c h re s u l t s from the de c i s i o n to i s s u e s e c u r i t i e s .
The ma n a g e r
be i n g awa re o f t h i s d i s t i n c t pos s i b i l i ty ma kes a d ec i s i o n reg a rd i n g
the amo u n t of fu n d s i n v e s ted i n the p roj ect , a s we l l a s t h e l e v e l
of s l a c k .
The v a l u e o f s l a c k i s d e r i ved from the ben e f i ts for c a r ry i n g
s l ac k .
I f a fi rm carri e s s l a c k , the i n v e s tme nt i n g rowth o pportu n i ty
i n c re a s e s a n d the pena l ty c o s t from the i s s u e of n ew s e c u r i t i e s
dec l i ne s .
Benefi t s a s s o c i a te d wi t h t h e h o l d i ng of s l a c k c a n be
ca l c u l a te d by c ompa ri ng two s i tu a t i o n s :
( a ) when t h e f i rm c a rr i e s
s l a c k , s ; a n d , ( b ) when t h e f i rm c a r r i e s zero s l a c k , i . e . , s =O .
For
e a c h one of the a bove a l tern a t i v e s the ma n a g e r c a n e i t h e r a c cept
the p roj e c t a n d i s s u e new s e c u r i t i e s , o r rej e c t the p roj e c t .
In
e s s e n c e , t h e re a re four c a s e s t h a t d e s c r i be a l l the a l t e rn a t i v e s
o p e n to ma n a g e rs .
Case #1 :
The fi rm ho l d s s l a c k a n d i s s ue s s e c u r i t i e s by
i n ves t i ng ( I - I * ) i n the proj e c t ( ho l d s l a c k , i s s u e
and i nves t ) .
U n d e r t h e s e c i rc umstance s , the f i rm•s
v a l u e c a n be e x p re s s e d a s :
V ( a c c e pt , I / s ) .
29
C a s e #2 :
The fi rm h o l d s s l a c k b u t i t does not i n v e s t i n the
proj ect ( ho l d s l a c k a n d do noth i n g ) .
The f i rm ' s
v a l ue i s g i v en by V ( re j e c t , I =O/ s ) .
C a s e #3 :
The fi rm h o l d s z e ro s l a c k a n d i s s u e s s e c u r i t i e s
by i n v e s t i n g ( I ' - I * ) i n the proj e c t ( i s s u e a n d i n v e s t
wi thou t s l a c k ) .
C a s e #4 :
T h e fi rm ' s v a l ue i s V ( a c c e p t , I ' / s =O ) .
The fi rm h o l d s z e ro s l a c k a n d i t doe s not i n v e s t
i n t h e proj e c t , i . e . do not h i ng .
I n thi s case ,
t h e fi rm ' s v a l ue i s e x p re s se d a s V ( re j e c t , I =O/ s =O ) .
From the a bove c a s e s t h o s e o f i n tere s t to u s a re c a se s # 1 a n d # 3 .
C a s e #2 dom i n a te s c a s e #4 .
The ma n a g e r ta k i ng i n to con s i d e rat i o n
the v a l u a t i o n e q u a t i o n ( 1 ) wi l l compa re the f i rm ' s v a l u e t h a t re s u l t s
from a l t e rn a t i v e d e c i s i o n s :
i s s u e , i n v e s t a n d c a rry s l a c k .
O u r mod e l h a s a d i s t i n c t c h a ra c teri s t i c :
i t s e p a ra t e s the
v a l u a t i o n o f a s s e t s i n p l a c e from t h e v a l u a t i o n of g rowth opportu n i t i e s .
I nv e s tme n t s i n a s s e t s i n p l a c e a re c on s i dere d a s rou t i ne repl aceme n t
ty pe de c i s i o n s .
I n v e s tme n t i n g rowth o p portu n i t i e s a re perce i v e d
a s not repe t i t i ve de c i s i on s .
O u r mode l a s s ume s t h a t t h e re i s o n e
pro f i tab l e o p portu n i ty i n whic h ma n a g e r s c a n i n v e s t i n f i n i te amo u n t
of c a p i ta l .
A l s o , i t i s i mp l i c i t l y a s s ume d t h a t i f the g rowth
opportu n i ty is a c c e p ted , the r i s k c h a ra c teri s t i c s o f the firm do
not c ha n g e , t h a t i s , the i n v e s tme nt opportu n i ty a n d the ex i s t i n g
a s s e t s be l ong t o t h e same ri s k c l a s s .
- --- -------- ----------- ------
30
I V.
A.
THE MAX I MUM L E V EL O F SLAC K
The C o s t F u n c t i o n
W h i l e t he re a re benefi t s f o r h o l d i ng s l ac k , t h e re a re a l s o
s ome re a s o n s for not ho l d i ng e x c e s s i v e l i qu i d b a l a n c e s .
C a r ry i n g
s l a c k i n a n t i c i pa t i o n o f profi tab l e g rowth o p portu n i t i e s i s a c o s t l y
Some o f the c o s t s i n v o l ved a re de s c r i bed be l ow .
p ro p o s i t i o n .
(1)
C o s t s a s s o c i a te d wi t h tax l i a bi l i t i e s .
I f s l ac k i s
i n v e s te d i n s ho rt te rm s e c u r i t i e s , taxes s ho u l d be pa i d
on i n tere s t earn e d .
(2)
Tra n s a c t i on c o s t s .
These c o s t s a re a s s o c i a te d w i t h t h e
acq u i s i t i o n , a s we l l a s the ma i n tenance o f s l a c k .
Acq u i r i n g s l a c k req uire s s e t u p c o s t s .
Ma i n tain i n g
u n u s e d debt c a pa c i ty , s u c h a s re v o l vin g c re d i t o r c re d i t
l i ne s , e n ta i l s payme n t s o f ma ndatory fee s .
(3)
Mon i to ri ng a n d / o r c o n t ra c t i n g c o s t s .
As a re s u l t o f
a symme t r i c i n fo rma t i o n a g e n cy p robl ems become i n te n s i ve .
Even i f we a s s ume pe rfe c t enforcea b i 1 i t;
of
the c ontrac�s,
the re a re c osts a s s o c i a te d w i th t h i s so l ut i o n .
The c o s t o f s l a c k s h ou l d be re l a ted to t h e c o s t o f c a p i t a l .
For s i mp l i c i ty i t i s a s s ume d t h a t if the c o s t o f c a p i ta l i s w , t h e
cos t of h o l d i n g s l a c k i s e x p re s s e d a s :
c(s)
B.
=
ws
(2)
The B e n e f i t s Deri ved from H o l d i ng S l a c k
I n o r d e r t o deri ve t h e bene fi t s o f ho l d i n g s l a c k w e wi l l
31
compa re the f i rm 1 S v a l ue when ma n a ge r s h o l d s l a c k a n d when they do
not h o l d s l a c k .
The di fference between the s e two s i t u a t i o n s wi l l
prov i de the i n c reme n t a l benefi t s fo r h o l d i n g s l a c k .
Later on i n
o u r a n a l y s i s t h e c o s t s o f h o l d i ng s l a c k a re c on s i d e re d .
U s i ng a
s i mp l e op t i m i z a t i o n tec h n i q u e c o s t s a n d benef i t s a re we i g hed ag a i n s t
e a c h o t he r , a n d t h e opti mum l e v e l of s l a c k i s d e r i v e d .
B a s ed o n
equat i o n ( 1 ) w e have :
The fi rm1 s v a l u e when i t ma i n ta i n s a l e v e l of s l a c k , s , i s g i ven
by :
V ( accept , I / s )
=
f(I*) + g ( I - I*) - p( I - I* , s )
(3)
The f i rm1s v a l u e wi t hout s l a c k i s g i ven by :
V ( acce pt , I 1/ o )
=
f( I * ) + g ( I 1 - I * ) - p ( I 1 - I * ,O )
(4)
By s u btra c t i ng ( 4 ) from ( 3 ) we c a n obta i n the a c t u a l bene f i t s
a s s o c i a te d wi th t h e ma i ntenance of s l a c k .
More s p e c i f i c a l l y , t h e
bene f i ts o f h o l d i ng s l a c k a re :
B
=
g ( I - I * ) - g ( I 1 - I ) + p ( I 1 - I * ,O ) - p ( I - I * , s )
(5)
I f the f i rms ho l d s z e ro s l a c k , the f i rm1 S va l u e i s max i m i z e d fo r
a
l ev e l o f i n v e s tment I 1 that s a t i sfi e s the f i r s t order c o n d i t i o n :
=
g 1 ( I 1- I * )
ap ( I 1 - I * , 0 )
aI
(6)
A l tern a t i ve l y , when the fi rm c a r r i e s s l a c k , i t s max i mum v a l u e wi t h
re s pect t o t h e i n v e s tme n t v a r i ab l e i s g i ven by :
i
g ( I-I*)
=
ap( I - I * , s )
aI
(7)
F i g u re 2 , page 2 3 , o ffe rs a n i l l u s tra t i o n o f c o nd i t i o n s ( 6 ) a n d ( 7 ) .
I t i s s h own that the s l ope o f the g ( . ) func t i o n fo r the i nv e s tme nt
32
l ev e l I i s · l e s s t h a n the s l o pe o f the s ame func t i o n at I ' .
Thi s i s
bec a u s e :
(8 )
Re l a t i o n (7 ) c a n be pre s e n ted a s fo l l ows :
H (l , s , p (l , s ) )
=
0
(8 . 1 )
I t i s a s s u med t h a t H ( . ) h a s c o n t i n u o u s part i a l d e r i v a t i v e s .
The
fu n c t i on H ( . ) defi nes a n i mp l i c i t func t i o n o f the form :
I = h (s , p (l , s ) )
(8 . 2 )
The tra n s i t i o n from (8 . 1 ) t o (8 . 2 ) t a k e s p l a c e u n d e r t h e a s s umpti o n s
nece s s a ry for t h e a p p l i c a t i o n o f t h e i mp l i c t - f u n c t i o n theorem .
1
Moreo ve r , i t i s a s s ume d t h a t the i mp l i c i t fu n c t i o n h ( . ) i s c o n t i n u o u s a n d h a s c o n t i nu ous pa rt i a l d e r i v a t i ves wi t h respect to the
a rgume n t s p and s .
Sub s t i tu t i ng (8 . 2 ) i n to ( 5 ) we obta i n a genera l e x p re s s i o n for t he
benefi t s a c c ru e d to ho l d i n g s l a c k :
B=g(h(s,p(l,s)) -I*) -g(l'-1*) +p(l'-1*,0) -p(h(s,p(l,s))- l*,s)
(9)
The l a s t e q u a t i on i n d i cates t h a t t h e bene fi t s o f s l a c k a re expre s s e d
a s fun c t i o n o f t h e i n v e s tme n t l e v e l , t h e pen a l ty fu n c t i o n , a n d t h e
amo u n t o f s l a c k c a r r i ed .
1
The i mp l i c i t-fu n c t i o n theorem s ta t e s t h a t fo r t h e i mp l i c i t
func t i o n flx , y ) =O there ex i s ts a ne i g hborhood o f p o i n t s a b o u t (x ,y )
s u c h t h a t for a ny x v a l u e i n t h e n e i g h bo r hood t here corre s po n d s a
u n i q u e y v a l u e i n the ne i g hborhood wi t h the prope rty t h a t f (x ,y ) =O .
I t i s a s s umed t h a t f (x ,y ) =O i s a cont i n u ou s fun c t i o n a n d t h a t i t
h a s c on t i n u o u s fi r s t pa rt i a l de r i v a t i v e s .
33
C.
The Opt i mum Amo u n t of S l ac k
The p re v i ou s a na l y s i s h a s s h own t h a t the v a l ue of s l a c k i s
d e r i ved f rom the net bene f i t s o f ho l di n g s l a c k .
T h a t i s , t h e v a l ue
of s l a c k i s the d i ffe re n c e betwe e n ben e f i t s and c o s t o f h o l d i n g
s l ac k .
We c a n o b ta i n the v a l ue of s l a c k by s u b t ra c t i ng eq u a t i on ( 2 )
from ( 9 ) :
v (s)
"' g ( h ( s p ( I s ) ) - I *) - g ( I I I *) + p ( I I I *. 0)
•
•
-
-
-
p (h (s p ( I s ) ) - I *. s) - ws
•
,
( 10)
The o p t i mum amo u n t of s l a c k i s de r i ved f rom the f i r s t o rd e r c ond i
t i on s o f ( 1 0 ) .
g1 ( h
s
+ h p ) - p1 ( h s + h p p 5 ) - p 5 - w
p s
=
0
(11)
or
( 12 )
( S u b s c ri pts p , s a n d I i nd i cate pa rt i a l d i fferen t i a t i o n o f func t i o n s
g , h a n d p w i th re s pect to p , s a n d I.)
The so l u t i o n of ( 12 ) p ro v i de s the o p t i mum amo u n t of s l ac k.
The
c o n d i t i o n fo r l oc a l maxi mum i s determ i ned f rom the s e c o n d
der i v a t i ve o f (10):
or
(gil - P11) (hs + hp ps) + (g 1
-
PI) ( hss + hp pll) - P11 < 0
By fo l l ow i ng t h e above s i mp l e o p t i mi z a t i o n procedure s , we c a n o b ta i n
th e o p t i mum l e v e l of s l a c k a s a fun c t i o n of the pen a l ty fun c t i o n ,
t he c o s t o f ca p i t a l , a n d t h e i mp l i c i t f u n c t i o n h ( . ) .
S i n ce t h i s
34
l a tter func t i o n , h { . ) , is dete rm i n e d by the i nv estme n t l e v e l i n the
g rowth o p po rtu n i ty , i t fo l l ows that re l a t i onsh i p { 1 1 ) p rov i des
i n d i re ct l y the assoc i at i o n betwe e n sl a c k a n d i n vestme n t .
D.
An Exampl e
W i t h o u t l oss of gene ra l i ty l e t us assume t h a t I *=O .
The
i nv estme n t i n the g rowth o pportu n i ty i s re p rese n t e d by t h e v a r i a b l e
x , i . e . , I - I *=x .
I t i s further assu me d t h a t :
g ( x ) = l og ( x ) , a n d
p ( x , s ) = ( kx ) l ( l +s )
whe re:
k i s a parame t e r su c h t h a t 0
�
k
�
1.
I f x ' i s the i n vestme nt l e v e l when t h e re are no sl a c k resou rces ,
equ a t i on ( 9 ) y i e l ds:
V ( s ) = l og ( x ) - l og ( x 1 ) + kx' - ( kxl ( l +s ) ) - ws
( 13 )
From c o n d i t i o n ( 7 ) we can deri ve the i mp l i c i t fu nc t i o n h ( . )
a l og ( x )
ax
_
a ( kxl ( 1 +s ) )
ax
( 14 )
x = ( 1+s ) I k
The refore , by su bst i tut i ng ( 1 4 ) i n to ( 9 ) we obta i n :
V ( s ) = l og ( ( 1+s ) 1 ( k ) ) - l og ( x ' ) + kx
I
- ( kl ( l +s ) ) ( l +s ) I k - ws
or
V ( s ) = l og ( l +s) - l og ( k ) - l og ( x ' ) + k x 1 - l -ws
The o p t i mum amou n t of sl a c k i s o b ta i ned from t h e f i rst d e r i vat i ve
of the a bove re l a t i o n .
11 ( l +s ) = w
s "' ( 1-w ) lw
( 15 )
35
Th i s i s afso the ma x i mum amo u n t o f s l a c k , s i nce the s e c o n d o rder
con d i t i o n s o f ( 15 ) wi t h re s pe c t to s i s nega t i v e
2
( V" ( s ) = - l / ( l + s ) ) .
V.
CONCLUS I ONS AND RE COMM E N DAT I ON S FOR F U RT H E R R E S EARCH
A n n o u n ceme n t e ffe c t s o f e x te rna l fi n a n c i n g may pre v e n t the
Thi s
fi rm from a c c e p t i n g a c o n t i n u u m o f s ame ri s k - c l a s s p roj e c t s .
i mperfe c t i o n l ea d s to a s u bopt i ma l i n v e s tment de c i s i on .
To ove r-
come th i s i mpe rfe c t i o n ma n a ge r s a re forced to ho l d f i n a n c i a l
re s o u rc e s before a n a n n o u n ceme n t o f the a c c e p t a n c e o f a n ew proj e c t
takes p l a c e .
H owe v e r , h o l d i n g s l a c k i n a n e ffort to a v o i d s ome
nega t i v e reacti on i n the c a p i ta l ma r ke t s i s a c o s t l y propos i t i o n .
Amo ng o t h e r e l emen t s , tax l i a b i l i t i e s a n d c o n t ra c t i n g c o s t s ma ke
ma n a g e r s c a u t i o u s re g a rd i ng the amou n t o f s l a c k t h a t t h ey s h oul d
carry .
I n th i s s e t t i ng , a n o p t i mum amou nt o f s l a c k repre s e n ts a
trade off between t h e c o s t s a n d bene f i t s of h o l d i n g s l a c k .
Benefi t s
o f h o l d i n g s l a c k i n c l u de t h e i nc re a s e d i nve s tme n t i n t h e g rowth
oppo rtu n i ty a n d the re d u c t i o n of t h e a d v e r s e p e n a l ty d u e to
exte rn a l f i nan c i n g .
A l t h o u g h s l a c k does not re s o l ve the s u bo p t i mum i n v e s tme nt
prob l em and the prev i o u s l y de s c r i be d i mperfecti o n , i t i s con s i dered
a s a v e h i c l e t h ro u g h wh i c h t h e f i rm i n t e rna l i z e s a ma rket externa l i ty .
I n o u r framewo r k a cos t l y a n n o u n ceme n t e ffe c t o f e x tern a l f i n a n c i ng
i s treated a s a ma rket extern a l i ty .
De s p i te i ts c o s t l y c o n s e -
q u e n ce s , i n terna l i z a t i o n o f c o s t l y e x t e rn a l f i na n c i ng offers a n
36
i mp roveme n t i n the i n v e s tment de c i s i on .
Cas so n ( 1 9 7 9 ) a n d Dunn i n g
( 1 981 ) h a ve de s c r i bed t h e i nt e rn a l i z at i on proce s s o f market i mperfect i o n s for a mu l t i nat i o n a l f i rm .
F i rms i n tern a l i ze c o s t l y
con s t ra i n t s a s s o c i ated w i t h the i nt e rn a t i o n a l i n s t i tu t i o n a l e n v i ronmen t .
f.1 rm .
A s i m i l a r a rg ume nt c a n be p re sented fo r t he case o f a dome s t i c
2
The s t u dy presented s eems to open new q u e st i o n s fo r e x p l o r i n g
i mporta n t to p i c s i n f i n a nc e t h e o ry i n genera l , a n d i n t h e a rea of
l i q u i d i ty i n pa rti cu l a r.
The b a s i c o b s e rv a t i o n ma d e i n t h i s s t u dy
i s t h a t t h e i n v e s tme nt dec i s i o n jo i n t l y wi th the de s i re to h o l d
s l a c k f i n a n c i a l re s o u rc e s h a s a n i n fo rma t i on c o n t e n t t h a t t h e ma r k e t
mu s t con s i de r i n the fi rm 1 S va l u a t i o n .
Al though i s sues o f s l ac k
s i g na l l i n g we re a d d re s s e d i nd i re c t l y i n t h i s e s s ay , i t i s conc e i v a b l e
t h a t man a ge r s , under certa i n con d i t i o n s , can s i g n a l to t h e ma r ket
the f i rm 1 s q u a l i ty by u s i n g a s a s i g na l l i n g dev i ce the amo u n t o f
s l a c k t h a t they h o l d before t h e i nv e s tmen t de c i s i o n i s made .
Thi s
ra i se s q u e s t i o n s a b o u t the n a t u re o f t h e a p p ro p r i a t e tec h n o l ogy ,
i . e . , the n a tu re o f the s i gna l t h a t f i rms s h o u l d a dopt so t h a t a n
eq u i l i br i um c o n d i t i o n i s o b ta i ned.
An e ffec t i v e s i g n a l s ho u l d a l l ow
ma rket pa rt i c i pan t s to d i s t i n g u i s h 11good11 f i rms from 11 b a d 11 o ne s ,
t h a t i s , the s i g n a l shou l d prov i de s e pa ra t i n g eq u i l i b r i um c o n d i t i o n s .
2
I nt e r n a l i z a t i on of a c o s t l y a n n o u n cement o f e x t e rn a l
f i na n c i n g may s i g n a l the f i rm 1 s i nte n t i on to 11 a p p ro p r i ate re n t s 11
a s s o c i a t e d w i t h po s s i bl e i n forma t i o n a b o u t t h e i nv e s tmen t de c i s i o n .
37
De s p i te the i n he re n t d i ffi c u l t i e s of a s i g n a l l i n g a pp roa c h
t o ou r p rob l em , t h e re a re some a l terna t i ve ro u t e s t h a t c a n be
e x p l o red i n a n effort to prov i de s ome exten s i o n to the p ro p o s e d
framewo r k .
O n e i n tere s t i ng a p p ro a c h i s t o co n s i d e r t h e pena l ty
funct i o n wi t h s ome a ddi t i o n a l a rgume n t s .
The natu re of f i n a n c i ng
( debt v s . equ i ty ) a n d the ty pe o f f i rm ( own e r c o n t ro l v s . ma n a g e
m e n t c o n t ro l f i rm ) a re two v a ri a b l e s t h a t c a n be i n c l u d e d i n the
Ba sed o n ou r pro p o s e d mode l , a n emp i ri c a l ana l y s i s
pen a l ty fu nct i o n .
can determi ne the actua l s i z e o f the pe n a l ty f u n c t i o n a n d the
re s pon s i v e n e s s o f the f i rm's va l ue to the a n n o u nceme n t s o f new
s e c u r i ty i s s u e s .
S t i l l an i n tere s t i ng exten s i o n wo rth ex p l o r i n g
i s the i s s u e o f a n o pti mum c a p i t a l s t ru c t u re fo r a f i rm t h a t c a n
i s s u e b o t h d e b t a n d equ i ty s e c u ri t i e s .
O u r mode l exami n e d the
s i mp l e s t c a s e of a n a l l equ i ty f i nan ced fi rm .
The s e l e c t i o n of
a c a p i ta l s t ru c t u re wi l l come o u t as a s eq u e n c e o f s t u dy i n g the
beh a v i o r of t h e pena l ty fu n c t i o n u n d e r d i ffe re nt s p e c i f i c a t i o n s o f
the ma i n a rgumen t s .
Another l i ne of a n a l y s i s i s the i n v e s t i g a t i on o f the a v a i l
a b i l i ty o f s l a c k i n a mu l t i pe r i od framewo r k .
A more prec i s e s ta t e
men t o f t h e i n v e s tme nt o pt i o n s i n a mu l t i pe r i o d s e tt i ng i s requ i re d .
When l oo k i n g i n re t ro s pe c t a t the ba s i c con c l u s i o n s o f t h i s
e s s ay , the no t i o n o f hol d i n g a n o p t i mum amo u n t o f s l a c k ha s an
i nt u i t i v e a p pe a l .
propos i t i o n .
U s e of f i n a n c i a l re s o u rces i s not a c o s t l e s s
S l a c k i s u s e d u p t o t h e po i n t t h a t ma rg i na l benef i t s
e q u a l t h e ma rg i n a l c o s t s .
. .
PART I
B I BL I OGRAPHY
39
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/�
¥
40
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d i s c r i mi n a n t a n a l y s i s a p proa c h , Paper p re s e n ted a t the Ea s t e rn
F i n a n c e A s s oc i a t i o n Mee t i n g s , ( O r l a n do , F l o r i da ) .
L e l a n d , H . , a n d D . Py l e , 1 9 7 7 ( May ) , I nfo rma t i o n a l a s symetr i e s , f i n a n
c i a l s t ru c t u re a n d f i n a n c i a l i nterme d i a t i o n , J o u r n a l of F i n a nc e
32 , 37 1 - 387 .
Mas u l i s , Rona l d , 1 980 , Sto c k repurc hases by t e n de r o ffe r : An a n a l ys i s
o f the c a u s e s of c ommon s to c k pr i ce c h a n ge s , J o u r n a l of F i n a n c e
35 , 305-3 1 9 .
Myers , S . , 1 9 7 6 , Modern deve l opme n t s i n f i n a nc i a l manageme n t , The
Dryden Pres s , Prae g e r P u b l i s hers .
Myers , S . C . , 1 9 7 7 , Determ i n a n t s of c o rpo rate borrowi n g , J o u r n a l o f
F i n a n c i a l Econom i c s 5 , 1 47 - 1 1 7 5 .
My ers , S . , 1 984 , The c a p i t a l s t ru c t u re p u zz l e , The J o u r n a l o f F i n a n c e
39 ( 3 ) , 5 7 5 - 592 .
Myers , S . , a n d N . Maj l u f , 1 984 , Stoc k i s s ues a n d i nv e s tme n t p o l i cy
when f i rms have i n fo rma t i o n t h a t i n ves tors d o n o t have , J o u rn a l
o f F i n a nc i a l Economi c s 1 3 , 1 8 7 -2 2 1 .
v'
41
Ro s s , S . , 1 97 7 ( S pri n g ) , The determ i n a t i o n o f f i n a n c i a l s t ructure s :
The i n ce n t i v e - s i g n a l l i n g a p proac h , The Be l l J o u r n a l o f Economi c s ,
2 3 - 40 .
Spence , M . , 1 9 7 3 ( Au g u s t ) , J o b ma r k e t s i gna l l i n g , Qua rter l y J o u rn a l o f
Econom i c s 87 , 3 5 5 - 3 7 9 .
Trueme n , B . , 1 983 , Mot i v a t i n g ma n a g e r s to reve a l i n s i de i n fo rma t i on ,
T he Jou rna l o f F i n an c e 38 ( 4 ) , 1 2 53- 1269 .
Va rma e l e n , Theo . , 1 98 1 , Commo n s to c k re p u rc h a s e s a n d ma r k e t s i gna l l i n g :
An emp i r i c a l s t udy , J o u r na l o f F i n a n c i a l E c o n om i cs 2 , 1 39 - 184 .
W i l l i ams on , 0 . , 1 9 66 , The e c o n om i c s o f d i s c re t i o n a ry behav i o r : Ma n a
g e r i a l objec t i ves i n t h e t h e o ry of the f i rm , Pre n t i c e - Ha l l .
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PART I I
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43
THE P R I N C I PAL -AGENT MODEL U N D E R A MULTI D I V I S I O NAL STRUCTURE
I.
I NTRODUCT I ON
The pri n c i pa l - a g e n t l i teratu re o ffers h e l pfu l i n s i g h t s
reg a rd i n g t h e r i s k a l l o ca t i o n amo ng the actors i n v o l v e d i n a
contractu a l re l a t i o n s h i p .
I n the p r e s e n t e s s ay we i n troduce a
mo d i f i e d v e rs i o n o f the s ta n d a r d p r i n c i pa l - a g e n t mo de l t h a t wi l l
a l l ow us to a n a l yze probl ems o f i n fo rma t i on and r i s k - s ha r i ng i n a
mu l t i d i v i s i o n a l fi rm .
Spe c i f i c a l l y , the paper exami n e s the p r i n c i pa l
agen t re l a t i o n i n a s e tt i ng t h a t e x p l i c i t l y ta kes i n to con s i dera t i o n
the i n tern a l o r g a n i z a t i o n a l s t ru c t u re o f t h e mo dern corpora t i on .
The fo rm o f i n te r n a l o rg a n i z a t i o n a l s t ru c tu re a l ters the
mo t i v a t i o n a l a s s umpt i o n s o f t h e a g e n ts e n g a g e d i n a c o n t r a c t u a l
rel a t i o n s h i p .
The a p pro a c h p r e s e n t e d h e re i n co rporates t h e i mpact
o f a mu l t i d i v i s i o n a l form o f o rg a n i z a t i on on the ri s k- s ha ri ng ru l e s
a n d compe n s a t i on s c hedu l e s , a s wel l a s on the va l u e o f i n fo rma t i on
i n the p r i n c i p a l - a g e n t framewo r k .
I t w i l l be a p p a re n t from the
d i s c u s s i o n i n the fo l l owi ng s e c t i o n s that the i n te rna l ma n a g e ri a l
s t ru c tu re , the n a t u re o f i n fo rma t i o n a b o u t d i v i s i on a l o u t pu t , a n d
othe r v a r i a b l e s p l ay an i mportant ro l e i n determi n i ng t h e r i s k
s ha r i ng ru l e s between the p r i n c i p a l a n d the a g e n t .
The exte n s i o n of the s t a n d a rd a g e n cy mode l to a framewo r k
t h a t c o n s i ders the i n terna l o rg a n i z a t i o n a l s t r u c t u re prov i de s
h e l pfu l s u g g e s t i o n s t o q u e s t i o n s rel ated t o t he a l l o c a t i o n o f o u t
come between t h e p r i n c i p a l a n d the a g en t .
Fo r examp l e , a n i n tere s t i n g
q u e s t i o n a ri s e s w h e n s omeone co n s i ders t h e i s s u e o f e ff i c i e n cy o f
44
the s h a r i n g ru l e :
i s i t a p prop ri a te to dev e l o p a s h a r i n g ru l e o n
t h e ba s i s of a g g re g a ted o r d i v i s i o n a l c a s h f l ows ?
The wo r k fo r t h i s re s e a rc h wa s mo t i v a ted by the o b s e rv a t i o n
t h a t the trad i t i o n a l theory o f a g e n cy de a l s wi t h o n l y o n e ty pe o f
f i rm :
the f i rm whose to p coord i n a t o r e x pend s h i s effort to accomp l i s h
one ta s k .
A c a re fu l rev i ew o f the c u rrent l i tera t u re re v e a l s t h a t
a l l t he re l e v a n t mo de l s have i so l a te d the ma n a ge r i a l fu nc t i o n from
the i n tern a l co rporate s t r u c tu re .
The top coord i n a t o r i s a s s ume d
to ma ke de c i s i o n s i n a b s e n c e o f a ny i n terna l re s t r i c t i o n s o r
co n s tra i n t s .
I t i s a l s o a s s ume d t h a t a l l pos s i b l e c o n f l i c t s that
a ri s e from the a l l oc a t i o n of the top ma n a ge r ' s e ffort a re c o s t l e s s l y
re s o l ve d .
I n o u r j u dgme n t the tra d i t i ona l pri n c i pa l - a ge n t mode l
can be e x te n de d to the d i re c t i o n o f a mu l t i d i v i s i o na l ma n a g e r i a l
e ffort t h a t wi l l a l l ow u s t o d raw s ome further i n s i g h t s o n i s s u e s
o f r i s k s h a r i n g a n d v a l ue o f i n fo rma t i o n .
A.
O rgan i z a t i o n o f t h e Pape r
The rema i n d e r of t h e e s s ay i s d i v i de d i n to fo u r s e c t i o n s .
Sect i o n I I b r i e f l y revi ews the re c e n t l i te r a t u re i n the a re a o f
agency theo ry .
W e prov i de a c l e a r d i s t i n c t i o n between two re l a ted
theore t i c a l mode l s :
the r i s k - s ha r i ng age n cy mod e l a n d the a g e n cy
mode l dea l i n g w i t h the a n a l ys i s o f c o n t ra c t i ng e n v i ronme n t .
We
a d d re s s s ome l i mi ta t i o n s t h a t a p pea r i n both mode l s , a n d i n a s u b
s e q u e n t s e c t i on we rev i ew the c u r re n t l i tera t u re de a l i n g w i t h t h e
ri s k - s h a r i n g a g e n cy mode l .
1
1
I n e s s e n c e , w e extend the l i t e ra tu re
A more i n - d e p t h a n a l ys i s o f the a g e n cy mode l de a l i n g wi t h
45
towa rds a d i re c t i o n that takes i n to account the mu l t i d i v i s i on a l
s tru c t u re of t h e modern corpora t i o n .
I n s e c t i o n I I I we exami n e the pri n c i pa l - a g e n t re l a t i o n s h i p
when t h e a g e n t i s the top c o o rd i n a t o r o f a mu l t i d i v i s i o n a l f i rm .
We bri e f l y re v i ew the mu l t i d i v i s i o n a l form o f o rg a n i z a t i o n a n d
j u s t i fy t h e mu l t i d i men s i o n a l i ty o f effo rt .
A l s o , w e exami ne how
t he r i s k - s h a r i n g ru l e s c h a n ge i f the top coord i n a t o r 1 S e ffort i s
mu l t i d i v i s i o n a l .
The r i s k - s h a r i n g a g e n cy mo de l , a fte r a p propri a te
a dj u s tmen t s , w i l l a d d re s s t h i s pro b l em .
propos i t i o n s a re i n t rod u ce d .
I n t h i s s e c t i o n t h e maj o r
Secti o n I V summa r i z e s t h e s i g n i f i c a n c e
of the re s u l t s obta i ned .
II.
A.
R E V I EW O F THE P R I N C I PAL-AGENT L I T E RATURE
A Taxon omy
E c o n om i s ts a n d s o c i a l s c i e n t i s t s , i n a n e ffort to e x p l a i n
why o rg a n i z a t i o n s ta ke the fo rm they do a n d why t hey be h a v e the way
they do , i n i t i a l l y a c cepted t h e i de a t h a t an organ i z a t i o n be h a v e s
a s a b l a c k box .
T h e 11 theo ry o f the fi rm11 wa s the f i r s t s te p towa rds
the u n de r s ta n d i n g o f the orga n i z a t i o n a l comp l e x i t i e s ; i t wa s de v e l oped
to a rt i c u l a te o n a set o f org a n i z a t i o n a l c h a ra c te r i s t i c s wh i c h co u l d
e x p l a i n t h e f i rm 1 s i n te rn a l s t r u c t u re .
Howev e r , t h e 11 theo ry of the
fi rm 11 i s e s s e n t i a l l y a theo ry of ma rke ts .
The fi rm i s mode l ed as
an e n t re p re n e u r who max i m i z e s , i n the a b s e n ce o f comp l i c a t e d
t h e c o n t ra c t i n g e n v i ronme n t a p p e a r s i n t h e t h i rd p a rt of t h i s
d i s s e rta t i o n .
46
behav i o ra l pro b l ems , pro f i t s o r v a l u e i n an e n v i ronme n t wh i c h i s
c ha ra c te r i z e d by pe rfect a n d c o s t l e s s e n forceab i l i ty o f c o n t rac t s .
The re a re no i n fo rma t i on probl ems , a n d a s a re s u l t , th i s me thod of
a na l y s i s has n o i mp l i ca t i o n s on how organ i z a t i o n s fun c t i on i n te rn a l l y .
De s p i te t h e fact t h a t c l a s s i ca l e c o n omi c concepts we re u s e d i n t h e
de v e l opme n t of the theory o f o rg a n i z a t i o n s , they we re not e n o u g h
to promo te a n u n d e r s tan d i ng o f the i n tern a l s t r u c t u re o f c o rpora t i o n s .
Moreover , pro b l ems o f i n tern a l re s o u rc e a l l oc a t i on were not d i s c u s s e d .
I t wa s o bv i ou s t h a t a s u b s t i t u t e o f the 1 1 b l a c k bOX11 wa s neede d .
The a g e n cy theory wa s deve l oped wi th the o bj e c t i v e of pro v i d i n g
s o l u t i o n s to a s e t o f comp l e x contractu a l a rra ngeme n t s t h a t de s c r i be
t he eq u i l i br i um be ha v i o r of ma x i m i z i ng a g e n t s who have d i v e r s e a n d
confl i c t i ng obj e c t i ves .
I n defi n i ng the fi rm a s a s e t o f con tracts ,
2
a tten t i o n i s c o n c e n t rated on t h e pro b l ems wh i c h the c o n t ra c t s a re
i n tended to s o l ve , that i s , o n how t h i n g s get done wi t h i n t h e
o rg a n i z a t i o n .
S i nce the o r i g i na l papers by S p e n c e a n d Ze c k h a u s e r
( 19 7 1 ) a n d Ro s s ( 1 9 7 3 ) , deve l o pme n t s i n t h e l i t e ra t u re h a v e foc u s e d
o n two d i ffe re n t a n d a l mo s t e n t i re l y s e p a rate a rea s .
The f i rs t ,
the c o n t ra c t i ng e n v i ronme n t theory o f age n cy , h a s foc u s e d o n the
a n a l y s i s o f the con tract i n g e n v i ronme n t and t h e n a t u re o f mon i to r i ng
and b o n d i n g a c t i v i t i e s of the f i rm 1 S c o n t r a c t s .
Maj o r wo r k s by
J e n s e n a n d Me c k l i ng ( 19 7 6 ) , Smi t h a n d Warner ( 1 9 7 9 ) , Mye r s ( 1 97 7 ) ,
Fama ( 1 980 ) , L e ftw i c h ( 1 98 1 ) , a n d Fama a n d J e n s e n ( 1 98 2 , 1983a , 1983 b )
2
P re c i s e l y , the fi rm i s d e f i n e d a s 11 a l e g a l e n t i ty t h a t s e rv e s
a s a n e x u s for a comp l ex s e t o f c on t ra c t s wri tten a n d u nwri tten . 11
( J e n s e n a n d Mec k l i ng ( 1 9 7 6 ) , p . 1 3 7 ) .
47
exami ne i n fo rma t i on c o s t s , deg ree o f c a p i t a l i n ten s i ty , t h e i n tern a l
a n d extern a l l a bor ma rke t s , a n d o t h e r fa ctors o f t h e con trac t i n g
e n v i ronme n t .
3
The s e cond a rea o f re s e a r c h i n t h e p r i n c i pa l - a g e n cy
re l a t i o n s h i p i s the ri s k- s ha r i ng t h e o ry of age n cy .
Amo ng t h e d i v e r s e
p ro b l ems a d d re s se d i n t h i s l i terature a re t h e fo l l ow i n g :
the
s t ru c t u re o f prefe re n c e s o f t h e part i e s e n g a g e d i n c o n t ra c t s , the
natu re o f u n certa i n ty , and the i n fo rma t i o n a l s t ru c tu re i n the e n v i ro n men t .
The s i g n i f i c a n t e l eme n t h e re i s the r i s k - s h a r i n g fo rm o f the
opt i ma l c o n t ra c t betwee n the p r i n c i p a l a n d the a g en t .
Papers of
t he r i s k - s ha ri ng theory o f a g e n cy i n c l u d e the wo r k s by Spence a n d
Zec k ha u s e r
M i rrl e e s
( 1 9 7 1 ) , Ro s s ( 1 9 7 3 ) , H a r r i s a n d Ra v i v ( 1 9 7 8 , 1 9 7 9 ) ,
( 1 9 7 6 ) , Town s e n d ( 1 9 7 9 ) , Ho l ms t rom ( 1 9 7 9 , 1 98 3 ) , Sap pi ng ton
( 1983 ) , and Shave l l ( 1 9 7 9 ) .
Both l i teratu re s a d d re s s the c o n t ra c t i ng prob l em .
d i ffer , h owe ve r , o n mathema t i c a l a n d emp i ri c a l g ro u n d s .
They
Speci f i c a l l y ,
the c o n t ra c t i n g e n v i ronme nt theory o f a g e n cy i s g e n e ra l l y conceptu a l
wi t h s ome emp i r i c a l o r i e n ta t i o n .
I n c o n t ra s t , t h e r i s k - s ha r i n g
theory o f a g e n cy i s hea v i l y ma thema t i c a l wi t h o u t a n emp i r i c a l
ori e n ta t i o n .
The fo rme r l i tera t u re p l a c e s emp h a s i s o n the u n d e r
s ta n d i n g o f the o b s e rved phe nome n o n a n d the c o s t s t r u c t u re a s s o c i a te d
wi t h i t .
T h e l a tter l i tera t u re s t re s se s t h e i mporta n c e o f the
v a r i a b l e s that de fi ne the pri n c i pa l - a g e n t re l a t i on rather than the
3
T h i s l i tera ture i s revi ewed i n the s u b s e q u e n t p a rt that
foc u s e s d i re c t l y on a s pe c t s of c o n t ra c t i ng e n v i ronme n t and f i n a n c i a l
dec i s i o n s o f a d i v i s i o n a l fi rm .
-
-- - ----
--
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-- ----
48
effe c t s of ma rkets a n d other factors on the c o n t ra c t i ng proce s s .
Tab l e 1 prov i de s further i n s i g h t o n the d i ffe ren c e s between the two
l i te ra t u re s .
The refore , we a re l e ft wi t h two s c h oo l s o f thou g h t t h a t
s eemi n g l y a d d re s s the same p ro b l em .
Howev e r , t he i r a n a l y t i c a l o r
conceptu a l a p pro a c h f o r re s o l v i n g pri n c i pa l - a g e n cy probl ems i s qu i te
di sti nct.
There a re q ue s t i o n s t h a t c a n b e a d d re s s e d o n l y w i t h i n
the c o n t ra c t i ng e n v i ronme n t theory of a g e n cy , b u t t h e a n swe rs needed
bel ong to t h e framework o f the r i s k - s ha r i ng theory o f a g e n cy .
Occas i o na l l y , gen e ra l q u a l i f i ca t i o n s re ga rd i ng a g e n cy p ro b l ems a re
des i ra b l e , b u t t h e i r v a g u e i n terpreta t i o n s a re not va l i d for po l i cy
de c i s i o n s .
Frequ e n t l y a heavy ma t h ema t i c a l o r i e n ta t i o n i s not
a tt ra c t i ve for p ra c t i ca l recomme n da t i o n s .
Obv i o u s l y , t h e re a re
l i mi t a t i o n s o f both a g e n cy framewo r k s regard i n g t h e n a t u re o f the
pro b l ems a d d re s s e d a n d t h e q u a l i ty o f t h e a n swe r s produced from t h e
ana l ys i s .
Des p i te the a bove-me n t i o n e d l i m i ta ti o n s , o u r c l a s s i f i ca t i o n
o ffe rs a c l e a r d i s t i n c t i o n amo n g t h e pa rameters t h a t p l ay a s i g n i f i
c a n t ro l e i n t h e a n a l y s i s o f c o n t ra c t u a l a r rangeme n ts among agen t s .
Howe ve r , a n o t h e r d i me n s i o n o f s i g n i f i c a n c e i s the i n tern a l organ i z a
t i o n a l s t ru c tu re , t h a t i s , t h e ty pe of f i rm .
I n ou r j u dgme n t t h e
t ra d i t i o n a l t h eo r i e s of t h e pri n c i pa l - a g e n cy re l a t i o n s h i p d e a l wi t h
on l y one ty pe o f f i rm :
t h e fi rm whose top coord i n a t o r a l l o c a t e s
h i s e ffort i n one prod u c t i v e a c t i v i ty .
Th i s paper a t tempts t o
d i ffe rent i a te t h e p r i nc i pa l - a g e n cy mode l s not o n l y a c c o rd i ng to t h e
49
Ta b l e 1
Two D i ffe r e n t Age ncy L i tera t u re s
THE R I S K- S HAR I NG
T H E CONTRACT I NG E N V I RONMENT
AGENCY THEORY
t
t
t
t
t
t
t
t
Con ceptu a l o r i e n ta t i o n
Emp ha s i s o n t h e a n a l y s i s o f
c o n t ra c t i n g e n v i ronme n t
C o s t/ Be n e f i t a n a l y s i s
B o n d i n g , mon i to r i ng c o s ts
a re i mpo rta n t v a r i a b l e s
An a l y s i s a t the fi rm ' s l ev e l
P o s s i b l e emp i ri c a l tes t i n g
hy po t h e s e s
C l e a r s e p a r a t i o n of own e r
s h i p a n d c o n t ro l
Fo c u s o n the e ffe c t o f
ma r ke t s o n c o n t ra c t i ng
proce s s
AGENCY THEORY
t
t
t
t
t
t
t
t
Mathema t i c a l treatme n t
Empha s i s o n t h e r i s k - s h a r i ng
fo rms o f a n o pt i ma l c o n t r a c t
Opt i mi z a t i on te c h n i q u e s
Stru c t u re of prefe re n c e s o f
a g e n t s a re i mporta n t
vari abl es
Ana l y s i s a t t h e pa rt i c i pa n t ' s
1 eve 1
D i ffi c u l t i e s w i th emp i ri c a l
te s t i n g
N o c l e a r s e pa ra t i o n o f own e r
s h i p a n d con t ro l ( d i s t i n c t i o n
i s i r re l ev a n t )
Focu s on t h e e ffe c t o f
a g e n t ' s prefe re n c e s o n the
contra c t i n g proce s s
50
s co pe o f a n a l yz i n g contra c t u a l a r ra n geme n t s amo n g a g e n t s , but a l s o
accord i n g to t h e fi rm 1 S ty pe .
D i s t i n g u i s h i n g between ty pes of
fi rms i s i mporta n t , bec a u s e t he r i s k - s h a r i n g ru l e s depend u pon
certa i n e l eme n t s o f the f i rm 1 S i n t e rn a l s t ru c tu re .
O bv i ou s l y , t h e re
a re s o many d i ffe ren t ty pe s o f f i rms i n the rea l worl d t h a t any
met h o d of c l a s s i fy i n g them i s s u bj e c t to the c r i t i c i s m o f be i n g
a rb i t ra ry .
Neverthe l es s , we h a v e deve l o ped a taxonomy o f f i rms
ba s e d o n two d i me n s i o n s :
t h e ty pe o f i n tern a l o r g a n i z a t i o n a l
s t ru c t u re , a n d the s c ope o f a n a l yz i ng a gency p ro b l ems .
W e have
concen trated s o l e l y u po n these two d i me n s i o n s beca u s e t hey have a
d i re c t re l a t i on s h i p to the c o n t ra c t u a l a rra n geme n t s between the
a g e n t and t h e pri n c i pal .
The fi r s t d i men s i o n , t h e ty pe o f i n tern a l
orga n i z a t i o n a l s t r u c t u re , c a n t a k e t h e d i s c rete v a l u e s o f a u n i ta ry
mode o r a mu l t i d i v i s i on a l form .
I n reg a rd to the s e c o n d d i men s i o n ,
t he s c o pe o f a n a l yz i n g the a g e n cy pro b l em , t h e prev i o u s d i s cu s s i on
h a s re vea l ed t h a t t h e re a re two mode l s that a n a l yz e con tractua l
rel a t i o n s h i ps :
t h e ri s k - s ha r i n g a g e n cy mod e l a n d t h e c o n t ra c t i ng
e n v i ronme n t a g e n cy mode l .
O u r poi n t i n i ntrodu c i n g t h i s taxonomy o f f i rms i s to
i l l u s t ra t e o u r bel i e f t h a t ( 1 ) d i ffe rent ri s k- s ha r i n g ru l e s s h ou l d
be formu l a ted for d i ffe re n t ty pes o f f i rms , a n d ( 2 ) t h e trad i t i ona l
a n a l y s i s of t h e pri n c i pa l - a g e n t mod e l a p pl i e s to a l i m i ted n umbe r
o f f i rms - -e v e n thou g h they may b e i mporta n t .
51
B.
Rev i ew of the Ri s k- S h a r i ng T h e o ry o f Age ncy
T h e c ommon c h a ra c t e r i s t i c o f the p a pe rs dea l i n g w i t h the
ri s k - s h a r i n g a gency theo ry i s the i n ve s t i g a t i on of an o p t i mum s ha r i n g
ru l e between t h e p r i n c i pa l a n d the age n t .
I n a d d i t i o n , emp ha s i s
i s p l aced u pon t he we l fa re c ompa r i s o n s o f the eq u i l i br i um- c o n t ra ct i n g
s o l u t i o n s i n the p re s e n c e of i n forma t i on c o s t s .
A l l the papers
rev i ewed p l ace a tten t i o n on the a n a l y s i s o f t h e s t r u c t u re o f p refere n c e s
o f t he pa rt i e s e n gaged i n c o n t ract s .
T h e refore , the fo c u s of the
r i s k - s h a r i n g l i terature i s o n t he i n fo rma t i on s t ru c t u re a t the l ev e l
o f par t i c i pa nts o r organ i z a t i ona l a c tors , rathe r t h a n on t h e f i rm ' s
1 eve 1 .
I n one o f the e a r l i e s t papers , Ross ( 1 973 ) i den t i f i ed a set
of u t i l i ty fun c t i ons that mot i vate t he a g ent to pe rfo rm a ta s k and
s t i l l i mprove the Pa re to effi c i e n cy .
H a r r i s a n d Rav i v ( 1 979 )
de v e l oped a t heo ry o f c o n t r a c t s a n d i n v e s t i g a t e d t he p ro b l em of how
the a v a i l a b i l i ty of i n forma t i o n af fec ts the s ha r i n g r u l e s .
F rom
t he i r a n a l y s i s , i t i s a p parent t h a t the opt i ma l c o n t ra c t , wh i c h
p rov i des i n cen t i ves to the age n t , depe n d s u pon the a va i l a b i l i ty o f
i n fo rma t i o n concern i n g effo r t .
S h a ve l l ( 1 979 ) exami n e d the re l a t i on
s h i p be tween o u tc ome , s h a ri ng ru l e s , a n d poten t i a l i n fo rmat i on a bo u t
the a g e n t ' s effort .
He a d d re s s e d the quest i o n of whe t h e r o r n o t
a ny a dd i t i o na l i nfo rma t i o n about t he a g e n t ' s effort i s u s e fu l .
Shave l l ' s re s u l t s i n d i c a te t h a t t he a g e n t ' s s h a re of t h e o u tcome
depe n d s to some extent on i n fo rma t i on wh i c h t h e p r i n c i pa l h a s a b o u t
h i s e ffo rt .
T h i s re su l t wa s a l s o p ro v e n by H o l mst rom ( 1 97 9 ) .
Howev e r , H o l mstrom ' s ana l y s i s i s more g e n e ra l i n t h a t i t de r i ves
52
the n e ce s s a ry and s u ff i c i e n t c o nd i t i o n s fo r i mp e r fe c t i nfo rma t i o n
t o i mprove the s h a ri ng ru l e .
T h e i mp l i c a t i o n o f t h i s s tu dy i s that
a ny i mpe r fe c t i n fo rma t i on a bo u t the a g e n t ' s effort can be u s ed to
i mprove the e ff i c i e n t a l l o cat i o n of ri s k s h a r i ng between the pa rt i e s
engaged i n a c o n t ract .
F i na l l y , S a p p i ngton ( 1983 ) i n ve s t i gated the
c o n t ra ct i ng re l a t i on s h i p i n a more rea l i s t i c s e t t i ng .
He a s s ume d
thut t h e a g e n t o b s e rves the s t ates of nat u re befo re he c h o o s e s the
l e ve l of e ffort a n d that t h e re i s a mi n i mum l o s s t h a t can be i m posed
on the a g en t .
H i s a na l y s i s i n d i c ates that the p r i n c i p a l w i l l n o t
offe r the a g e n t a f i rst-be s t c o n t ra c t .
One o f t h e l i m i ta t i o n s o f the r i s k - s ha r i ng t h e o ry o f a g e n cy
i s t h a t i t d e s c r i bes how the top c o o rd i nato r expends effort to ma nage
effect i v e l y ju s t one produ c t i o n fa c i l i ty .
Howe v e r , c ommon o bse rva b l e
be ha v i o r o f ma nagers has s h own t h a t "e ffo r t " c o n ta i n s many s u bta s k s .
I t i s rea son a b l e to conje c t u re t h a t , depe n d i ng on the c r i t i ca l
i mportance o f t h e t a s k a n d t h e d i s u t i l i ty a s s o c i a t e d w i t h the
spec i f i c ta s k , ma nagers wou l d c o n c e n t rate t he i r e ffort i n a sma l l
number o f t a s k s .
Bounded ra t i o n a l i ty , a symme t r i c i n fo rma t i on , a n d
o t h e r beh a v i o ra l p ro b l ems l i mi t t h e top c o o rd i n a t o r ' s a b i l i ty to
ma nage s i mu l taneous l y a l l the ta s k s .
III.
A.
T H E P R I N C I PAL-AGENT MODEL UNDE R A MUL T I P L E - E F FORT STRUCTURE
E l eme n t a ry Co n s i d e ra t i o n s
T h e pri nc i pa l -agent mo de l a p p l i e s t o s i tu a t i o n s wh i c h a re
characte r i z e d by the fo l l ow i n g s t ru c tu re :
o n e i n d i v i dua l , c a l l e d
the a g e n t , c h o o s e s some a c t i o n to p r o d u c e an o u t c ome , wh i c h w i l l
--
--
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53
be d i v i de d between the a g e n t a n d a n o t h e r i n d i v i d u a l , c a l l ed t h e
pri n c i pa l .
The pa rt i cu l a r o u t c ome depends on the a g e n t 1 s e ffort
a n d the s t ate o f the wo rl d t h a t a c t u a l l y preva i l s at that re l a t i v e
t i me .
I n t h e mo s t genera l c a s e the a g e n t 1 s a c t i o n s c a n n o t be
o b s e rved d i rec t l y , a l thou g h the re s u l t i ng outcome g e n e ra t e s u t i l i ty
to the pri n c i pa l .
The a g e n t i n re tu rn for h i s e ffort rece i v e s a
payme nt from the pri n c i pa l .
The refore , the a g e n t 1 s u t i l i ty depe n d s
on the payme nt a n d the e ffort extended t o a c c omp l i s h a ta s k .
The
maj o r p ro b l em i n des i g n i ng a c o n t ra c t between t h e a g e n t a n d the
pri n c i p a l i s t h e u n o b s e rv a b i l i ty of t h e agent 1 s e ffort .
The l a c k
o f o b s e r v a b i l i ty o f effort i mp l i e s t h a t the a g e n t w i l l c h oo s e a n
e ffort t o ma x i mi ze h i s own e x pe c ted u t i l i ty , a n d t h i s i n g e n era l
mea n s t h a t the c o n t ract between the p r i n c i pa l a n d the a g e n t doe s
not re f l e c t o pt i mum ri s k s h a r i n g .
Accord i n g to the a n a l y s i s prov i de d
by H o l mstrom ( 1 9 7 9 ) a n d o t h e r s , t h e mo ra l - ha z a rd p ro b l em a ffec t s
the Pa reto - o pt i mum ri s k s h a r i n g between the a g e n t a n d t h e p r i n c i pa l ,
s i mp l y be c a u s e t h e acto rs e n g a g e d i n a c o n t ra c t u a l re l a t i o n pos s e s s
d i ffe re nt i n fo rma t i o n a l s e t s .
To dea l wi th t h i s prob l em , the p r i n c i pa l c a n c o n s i de r one
of the fo l l ow i n g s t rateg i e s .
The f i r s t s t ra tegy , s u g g e s t s that
the p r i n c i pa l pays the a g e n t a f i xed wa g e .
i s reta i ne d by t h e pri n c i pa l .
Any re s i du a l o u t come
T h i s s t ra tegy i mp l i e s t h a t t h e a g e n t
d o e s not h a v e a ny rea l e c o n omi c i n c e n t i ve t o pe rfo rm t h e a g reed
l ev e l o f e ffort , s i nce an u n a c c e p ta b l e outcome c a n be j u s t i f i ed
on u n c o n t ro l l a b l e facto r s ( i . e . , a ba d s ta te ) .
I t i s we l l
u nd e r s t o o d t h a t t h e p r i n c i pa l a vo i d s c o s t l y i n cent i ve s c heme s ,
---
--
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54
a l t hou g h he faces the r i s k of rec e i v i n g a s u bop t i mum o u t c ome .
The
s e c o n d s t ra te gy rec omme n d s that the pri n c i p a l rents t h e f i rms to
the a g e n t for a f i x e d c o s t a n d foregoes any c l a i ms on the res i du a l
outcome .
T h i s s t rategy i mpo s e s a s u bop t i ma l l ev e l o f ri s k on the
a g e n t s i nce , reg a rd l e s s o f the outcome o f the s t ate v a r i a b l e , h e
wou l d h a v e to compensa te the p r i n c i p a l on the ba s i s o f a p redeterm i n e d
fee .
Certa i n l y , th i s a p p ro a c h fa v o rs the p r i n c i p a l by prov i d i n g
g a i n s from ri s k s h a r i ng , but i t i s q u e s t i ona b l e i f t h e a g e n t
v o l u n ta r i l y wi l l s u b s c r i be t o t h i s recomme n d a t i o n .
s t ra tegy s u g g e s t s a comp rom i s i ng s o l u t i on .
s ome i n c e n t i ve s to the a g en t .
The t h i rd
The p r i n c i p a l o ffe rs
I n deed , the pri n c i pa l s ' o bj e c t i v e
wi l l be to tradeoff s ome g a i n s from s h a r i ng ri s k w i t h s ome c o s t s
o f prov i d i ng i n c e n t i ves t o the a g en t .
I n ce n t i v e s t h ro u g h a n emp l oy
me n t c o n t ra c t wi l l i mpose s ome ri s k on t h e a g e n t i n o rder to
mot i va te h i m to e x p e n d s ome a g reed l e v e l of e ffort .
A l t h ou g h t h e t h i rd s t ra te gy i s more rea l i s t i c , i t e n t a i l s
c on s i dera b l e comp l i ca t i o n s i n terms o f a fea s i b l e s o l u t i o n , i n
parti c u l a r , i n v i ew o f t h e fa c t t h a t t h e a g e n t a l way s h a s a
d i s u t i l i ty fo r h i s e ffo rt .
O bv i o u s l y , the pri n c i p a l mu s t t a k e i n to
a ccou n t t h e fact that h i s c h o i ce o f a c ompe n s a t i on fee w i l l dete r
m i ne t h e l e v e l of the a g e n t ' s effort v i a the a g e n t ' s u t i l i ty
max i m i z a t i o n pro c e d u re .
Th i s l e a d s to a depa r t u re from t h e o pt i mum
r i s k - s h a r i ng s o l u t i o n .
W i t h a n a p propri a te i nc e n t i v e s c h eme , the a b o ve -men t i oned
p ro b l em c ou l d be a v o i de d .
I n c e n t i v e s t h ro u g h a n emp l oyme n t c o n t ra c t
55
wi l l i mpo s e s ome r i s k o n the a g e n t i n o r d e r to mot i v ate h i m t o
e x p e n d s ome a g reed l ev e l of e ffort .
H o l mstrom ( 1 9 7 9 ) , H a rr i s a n d
Rav i v ( 1 9 7 9 ) , S h a v e l l ( 1 9 7 9 ) a n d S h a p p i n g ton ( 1 983 ) exami ned t h e
opt i ma l i n ce n t i v e s c heme s ( i . e . , s h a r i ng ru l e s ) u n d e r t h e a s sump t i o n s
t h a t e i t h e r t h e a g e n t ' s e ffort i s pe rfec t l y o b s e rv a b l e o r t h a t t h e re
a re i mperfect i nd i cators o f t h e a g e n t ' s e ffo rt .
F i r s t a n d s econd
best s o l u t i o n s o f a n i n cen t i ve c o n t ra c t a re f i na l l y d e r i v e d u nd e r
d i s t i nc t preference s t r u ctu re s , i . e . , w h e n a g e n t s a re neu tra l o r
r i s k a v e rs e .
The who l e a n a l y s i s i s b a s e d o n a n e x p e c te d u t i l i ty
mode l wh i c h re pre s e n t s the prefe re n c e s o f the pri n c i p a l a n d the
age n t .
The d i s u t i l i ty o f the agent re g a rd i n g the effort c reates
the mora l h a z a rd prob l em , bec a u s e o f the pri n c i p a l s ' i n a b i l i ty to
o b s e rve perfe c t l y the a g e n t ' s a c t i o n .
B.
Mu l t i d i v i s i o n a l E ffort
Howev e r , the mora l h a z a rd pro b l em has been d e f i n e d u n de r the
l i mi te d case o f a u n i d i me n s i ona l e ffort .
i n a ra t h e r n a r row s e n s e .
Effort has been determ i n e d
I n prac t i ca l s i t u a t i o n s a g e n t s a re
c o n fro n t e d wi t h s e v e ra l ta s k s s i mu l taneo u s l y .
For e x amp l e , a
ma n a g e r i s fa c e d w i t h more t h a n one respon s i b i l i ty wh i c h compri s e s
h i s fu n c t i o n .
I n a n extreme c a s e , i f t h e re i s j u s t one re s p o n s i b i l i ty
i t can be de f i n e d a c ros s d i ffe re n t q u a l i ta t i ve d i me n s i on s .
I n more
pract i c a l terms , the top ma n a g e r o f a mu l t i d i v i s i o n a l f i rm i s
c h a rged wi t h the s u perv i s i o n o f s e v e r a l prod u c t i o n pro c e s s e s a n d
t h e d i re c t i o n o f a l l t h e d i v i s i o n s .
A mu l t i d i v i s i on a l e ffort
56
appro a c h to the p r i n c i p a l - a g e n t p ro b l em i s defi n i te l y d e s i ra b l e ,
s i nce i t p ro v i de s a more re a l i s t i c f ramewo r k w i t h i n wh i c h i n c e n t i ve
p ro b l ems can be exami ne d .
To s u b s ta n t i ate ou r a rgume n t fo r a mu l t i d i v i s i on a l e ffort ,
we ex ami ne t h e pa rt of the l i tera t u re that de a l s w i t h the i n tern a l
o rg a n i z a t i o n a l s t r u c t u re .
4
I t i s t ru e t h a t mu l t i d i v i s i o n a l s t ru ctu re s
have been doc ume n te d by many re s e a rc h e r s a n d t h a t b o t h t h e i n du s t r i a l
o rg a n i z a t i o n l i tera t u re a n d the ma n a g eme nt l i teratu re have e x ha u s t i ve l y
exam i n e d q u e s t i o n s addres s i n g the d e g ree of d e c e n t ra l i z a t i o n , s pa n
o f c o n t ro l , a n d o t h e r norma t i v e a n d behav i o ral facto rs a ffec t i ng
o rga n i z a t i o n a l de s i g n .
C h a nd l e r ( 1 9 7 7 , 1982 ) p ro v i ded a n a n a l ys i s
o f the t ra n s fo rma t i o n o f the c o rporat i o n from i t s u n i t a ry fo rm
( U - form) to i t s re cent mu l t i d i v i s i o n a l MD-form .
Armo u r a n d Teece
( 1 978 ) and Teece ( 1 981 ) doc ume n ted a po s i t i v e c o r re l a t i o n between
profi ta b i l i ty and mu l t i d i v i s i o n a l form o f o rg a n i z a t i o n .
I n deed ,
t h i s fi n d i ng j u s t i f i e s the a d o pt i on o f the mu l t i d i v i s i o n a l form .
Wi l l i am s o n ( 1 9 7 3 , 1 9 7 5 ) a rg u e d t h a t t h e mu l t i d i v i s i on a l form i s the
outcome o f t h e prod u c t a n d c ap i ta l ma rket 1 S i n a b i l i ty to reg u l a te
dec i s i o n ma k i ng i n c o rpora t i o n s .
C o n s e q u e n t l y , t h e f i rm i n tern a l i z e s
potent i a l externa l i t i e s a n d b e h a v e s a s a mi n i a t u re c a p i ta l ma rket
i n terms o f a l l o c a t i ng re s o u rce s .
A re l a ted body of l i tera t u re
exami n e d a s pe c t s o f i n terna l admi n i s t rat i v e re g u l a t i o n a n d i n ce n t i v e s
i n l a rge o r g a n i z a t i o n s .
4
S i mo n ( 1 9 57 ) , W i l s o n ( 1 9 7 5 ) s S t i g l i tz ( 1 9 7 5 ) ,
T h i s l i teratu re i s rev i ewed exte n s i v e l y i n the s u b s e q u e n t
e s s ay t h a t foc u s e s on the f i n a n c i ng de c i s i o n s o f the mu l t i d i v i s i o n a l
c o rpora t i o n .
57
Al c h i a n a n d Demsetz ( 1 9 7 2 ) , M i rrl e e s ( 1 9 7 2 ) , a n d W i l l i amson ( 1 9 7 5 )
pro v i ded rea s o n s t h a t e x p l a i n why fi rms a dopt h i e ra rc h i e s .
The refore ,
the c u rrent l i teratu re h a s e s t a b l i s h e d that t h e mu l t i d i v i s i o n a l
s t r u c t u re i s a c ommon fo rm o f organ i z i n g economi c a c t i v i t i e s a n d
that t h e h i e ra r c h i ca l s t ru ctu re a l l ow s t h e t o p ma n a g e r t o coord i n a t e
a c t i v i t i e s among d i v i s i o n s .
From the a bove d i s c u s s i o n , i t i s rea s o n a b l e to a s s ume t h a t
the top c o o rd i n a t o r s u pe rv i s e s t h e o p e ra t i o n of n - d i v i s i on s of a
d i vers i fi e d corpora t i o n .
H i s e ffort i s mu l t i d i v i s i o n a l i n the s e n s e
t h a t h e a l l o c a te s a fra c t i o n o f h i s overa l l p ro du c t i v e a b i l i ty to
each d i v i s i on .
Depend i ng o n the a g e n t ' s ri s k a tt i t u de s , a n
a p p ro p r i a t e s ha r i n g ru l e wi l l determi ne t h e a l l oc a t i o n o f t h e f i rm ' s
ou tpu t ( c a s h f l ow ) between the pri n c i p a l a n d the a g en t .
Howev e r ,
a mu l t i d i v i s i on a l e ffort ra i se s i s s u e s o f the o p t i ma l i ty o f s h a r i ng
ru l e s a c r o s s d i ffe re n t produ c t i ve a c t i v i t i e s .
From the p r i n c i pa l ' s
poi n t o f v i ew the i n forma t i ona l a symme t ry prob l em become s mo re
comp l i c a te d , be c a u s e i t e n t a i l s con d i t i o n s of i mperfect o b s e rva b i l i ty
a c ro s s many d i v i s i o n a l o u t p u t s ( ca s h fl ow s ) .
Anothe r p ro b l em i s
a s s o c i a t e d wi t h t h e i mp l i c i t a s s umpt i o n t h a t t h e a g e n t ha s s u p e r i o r
i n fo rma t i on a n d co rre c t a s s e s sme n t s concern i ng d i s u t i l i t i e s of
d i ffe re n t ta s k s .
Th i s pre s u p p o s e s the a b s e n c e of any mi s i n fo rma t i o n
pro b l ems down i n the h i e ra rchy .
T h e re fo re , a n a p p l i c a t i o n o f t h e
ri s k - s h a r i ng a g e n cy mod e l to t h e c a s e o f a mu l t i d i v i s i on a l e ffort
n a t u ra l l y s u ffe rs from l i mi ta t i o n s re l a ted to t h e i mposed a s s umpt i o n s .
58
In a d d i t i o� , s ome e l eme n t s a re m i s s i n g from the a n a l y s i s .
5
De s p i te
the s h o rtcomi n g s i n o u r a n a l y s i s , ou r mode l s prov i de a f i r s t a p p ro x i ma t i o n to a s o l u t i on of a n a l re a dy comp l i cated p ro b l em .
C.
The Mode l
The deve l opme nt o f ou r mod e l takes p l a c e u n d e r t h e mo s t
genera l con d i t i o n s .
I n s u b s e q u e n t s e c t i o n s a l terna t i v e s pe c i fi c a -
t i o n s o f t h e mode l wi l l b e d i s c u s s e d .
We p ro v i de t h e fo l l ow i ng
s cena r i o a l ong the maj o r a s s umpt i o n s :
(1)
A f i rm co n s i s t s o f n i n de pe n dent di v i s i o n s .
h a s a c a s h f l ow ( o u t come ) o f x .
i
Each d i v i s i on
The a dd i t i o n o f ca s h fl ows
from a l l d i v i s i on s p ro v i d e s the fi rm ' s o v e ra l l o u t c ome X .
(2)
The pri n c i pa l h a s a u t i l i ty fu n c t i o n o v e r t h e mo n e t a ry ou tc ome
wh i c h i s g i ven by the fu n c t i on G ( . ) .
G ' > 0. and G "
<
0.
I t i s a s s umed that
G ( . ) i s a rea l funct i o n of the ty pe
R-->R.
(3)
The pri n c i pa l de l e g a t e s to a n a g e n t a u t h o r i ty for t h e de c i s i o n
ma k i n g a n d coord i na t i on o f t h e fi rm ' s u n i t s .
expends
a n e ffo r t , w h i c h t o g e t h e r w i t h t h e
The a g e n t
re a l i z a t i o n o f
a n u n certa i n s ta te v a r i a b l e , w , wi l l determ i ne the f i rm ' s
c a s h f l ows .
(3. 1)
The f i rm ' s c a s h fl ows a re d e r i ved from the fu n c t i on X =y ( e , w ) ,
whe re w i s the s ta te v a r i a b l e , a n d e i s the a g g regate
effort .
5
2
2
I t i s a s s ume d dX/ de > 0 a n d d x; de
.s.
0 for a 1 1 w .
other mi s s i n g v a r i a b l e s a re the pay s t ructu re for u n kn own
a b i l i ty , the l a bor ma r ket c o n s i de ra t i o n s , a n d t h e t e c h no l og i ca l
con s t ra i n t s .
59
(3.2)
The e ffort devoted to the ma n a geme n t of the i d i v i s i o n i s
1
e..
The a d d i ti v i ty prope rty can be a p p l i e d for d i v i s i o n a l
e ffo rts .
The l e v e l o f e ffort expended by t h e a g e n t c a n be
o b s e rva b l e o r u n o b s e rv a b l e .
(3.3)
The a g en t ' s overa l l u t i l i ty fu n c t i o n wi th re s pe c t to e ffort
a n d ou tcome i s H ( X , e ) = U ( X ) - V ( e ) .
s a t i s f i e s t h e con d i t i o n s U '
>
The a g e n t ' s fu n c t i o n U ( X )
0 , U"
<
0.
I n a d d i t i o n , the
agent dema n d s a mi n i mum l e v e l of u t i l i ty , H* , wh i c h i s
determi n e d by h i s opportu n i ty s e t a n d o t h e r e x o g e n o u s fa c to r s .
(3.4)
The a g e n t h a s n a rrow a tomi s t i c i n ce n t i v e s a n d h a s d i s u t i l i ty
for t h e effort e wh i c h i s g i ven by V ( e ) .
The fu n c t i o n V ( . )
i s d e f i n e d over e ffo rt a n d i n the fi e l d R - � R .
p ro pert i e s o f th i s func t i o n a re V ' ( . )
(4)
>
Maj o r
0, and V" ( . )
2.
0.
The o u tcome X i s a l l o c a te d a fter the e n d o f t h e pe r i od
between the pri n c i pa l and the a g en t .
The s h a r i n g ru l e , s ( . ) ,
s pe c i f i e s the amo u n t o f o u t p u t that g o e s to the a g e n t .
p r i n c i pa l rece i ve s X - s ( . ) .
known .
The
The e x t reme v a l u e s o f s ( . ) a re
The s h a r i ng ru l e s ho u l d have a n u p per a n d a l owe r
l i mi t fo r t h e occu rre n c e o f a s o l u t i on .
F i n a l l y , t h e s h a r i ng
ru l e i s mea s u rab l e .
(5)
T h e re i s a n n - d i me n s i o n a l v e c t o r x ' t h a t i n d i cates d i v i s i on a l
pe rforma nce .
(x
(6)
l'
x
2' ' "
I f we con s i d e r n - d i v i s i on s , x ' i s e q u a l to
x ).
n
The j o i n t de n s i ty f u n c t i o n o f x a n d e i s g i ve n by f ( x , e ) .
For a g i ve n l e v e l o f e ffort e , both t h e p r i n c i pa l a n d the
--------------------
60
a g e n t have i de n t i c a l be l i e fs a b o u t the c o n d i t i o n a l p roba b i l i ty
d i s t r i bu t i o n over the o u tcome .
A l s o , i t i s a s s u me d t h a t t h e
p a rt i a l d e r i v a t i ves o f f ( . ) wi t h re s p e c t to e a c h d i v i s i o na l
e ffort ex i s t .
F i na l l y , t h e ma rg i n a l cumu l a t i ve d i s t r i bu t i o n
fu n c t i o n s a re a s s umed t o s a t i s fy fi r s t o rder s to c h a s t i c
domi n a n c e .
That i s , i f F ( x , e ) i s the ma rg i n a l cumu l a t i ve
i i
d i s t r i bu t i o n fu n c t i o n o f e , then F 1 ( . )< 0 .
i
(7)
We denote by a rgmax ( . )
the s e t of a rgume n t s t h a t ma x i m i z e
the expre s s i o n i n p a re n t h e s i s .
The fo l l owi n g formu l a t i o n con s i ders the c a s e o f a n u n o b s e rv a b l e
e ffort .
Genera l l y , the pri n c i p a l 1 S probl em i s g i v e n by the set o f
equati ons :
Max
s ( . ) ,e
s u bj e c t to :
_/'
( 1. 1 )
G( X-s ( X ) ) f( X , e )dX
J
( u ( s ( X ) ) - V ( e ) ) f ( X , e ) dX � H*
e
E
a rgmax
J
( u ( s ( X ) ) - V ( e ) ) f ( X , e ) dX
(1.2)
(1.3)
I t i s a s s ume d t h a t the max i mum o f the e x p re s s i o n ( 1 . 3 ) ex i s t s
a n d i t i s a me a s u ra b l e q u a n t i ty .
The refore , the l a s t e q u a t i on c a n
b e s i mp l i f i e d t o the set of e q u a t i o n s ( n -e q u a t i o n s ) :
U ( s ( X ) ) f ( X , e ) dX = V ( e ) , for i = 1 , 2 , . . . n
i
1
1
where V . ( e ) = d V ( e ) / de .
(1.4)
61
When x '
=
· ( x , x , x . . . x ) i s o b s e rv a b l e a n a l tern a t i ve s p e c i f i c a
1 2 3
n
t i o n o f t h e mode l i s a s fol l ows :
Max
s ( . ) ,e
�
G ( X-s ( x ' ) ) f ( X , e ) dX
( 1.5)
s u bj e c t to :
�
( U ( s ( x ' ) ) - V ( e ) ) f ( X , e ) dX 2. H*
e
t:
a rgmax
�(
U ( s ( x ' ) ) - V ( e ) ) f ( X , e ) dX
( 1.6)
(1.7)
Di s c u s s i on
The p r i n c i pa l ' s pro b l em i s to s pe c i fy a s h a r i n g ru l e that
ma x i m i z e s h i s e x pe c ted u t i l i ty .
wi t h t h e fo l l owi n g re qu i reme n t s :
T h i s s h a r i n g ru l e s h ou l d c omp l y
( a ) i t s h ou l d compen s a te the a g e n t
fo r the e ffort he e x p e n d s i n a c c omp l i s h i ng the ta s k , a n d ( b ) i t
s hou l d be s u ffi c i e n t to mo t i v a te the a g e n t to pe rform t he a g reed
tas k .
The p r i n c i pa l i s i n d i ffe rent to t he agent ' s c h o i ce o f effort
as s u c h , a n d i s con cern e d on l y w i t h the v a l u e of the o u t c ome net
o f the por t i o n that mu s t be pa i d to the age n t .
The p r i n c i pa l ' s obj e c t i v e fu n c t i on i s g i v e n by t h e a bove
equati on ( 1 . 1 ) .
I f the a g e n t ' s e ffort i s obs e rva b l e , t h e p r i n c i pa l
max i mi z e s h i s u t i l i ty fu n c t i o n G ( . ) s u bj e ct to the c on s t ra i n t ( 1 . 2 ) .
T h i s c o n s t ra i n t expre s s e s t he c o n d i t i on t h a t the p r i nc i pa l ' s s h a re
i s determ i n e d i n s u c h a way that a m i n i mum e x pe c ted rewa rd for the
a g e n t i s c o n s i dere d .
The mi n i mum rewa rd for the a g e n t , H* , i s
determi n e d by the compe t i t i ve l a bor ma r ke t forces a n d o t h e r fa c to r s
outs i de the p r i n c i pa l ' s i n f l u e n c e , t h a t i s , the H* l e v e l i s
exogenou s l y dete rmi ne d .
62
C o n s tra i n t s ( 1 . 2 ) repre s e n t a fo rc i ng c o n tract for t h e
pri n c i pa l .
I f t h e a g e n t ' s e ffort i s n o t o b s e rv a b l e , t h e p r i n c i pa l ' s
max i m i z a t i on pro b l em i s c o n s tra i n e d by a n a dd i t i o n a l c o n d i t i on , t h e
re l a t i o n s h i p ( 1 . 3 ) .
The c o n s t ra i n t ( 1 . 3 ) i n d i c a t e s t h a t the s e l f
i ntere s t e d agent w i l l choose a l ev e l o f effort s o t h a t h i s u t i l i ty
net o f a ny c o s t s a s so c i a t e d w i t h t h e a l l oc at i on o f effort i s ma x i
mi z e d .
I t i s i mp l i c i t l y a s s umed t h a t t h e c o s t o f e ffort for t h e
a g e n t i s a mea s u ra b l e q u a nt i ty a n d i s refl ected i n t h e fu n c t i o n
V ( e ) , wh i c h i s the d i s u t i l i ty o f effort .
Obv i o u s l y V ' ( e )
>
0.
T h e re fore , t h e pri n c i pa l mu s t ta ke i n to c o n s i de ra t i o n t h e
fa c t t h a t h i s c h o i c e of a s ha r i n g ru l e w i l l determ i n e t h e v a l ue o f
e ffort v i a t h e a g e n t • s max i mi za t i o n procedu re .
The o n l y fea s i b l e
s o l u t i o n for t h e pr i nc i pa l wou l d be t o p ro v i de s ome i n c e n t i v e s to
the a g en t .
More s p e c i f i ca l l y , t h e p r i n c i pa l tra d e s o ff s ome ga i n s
from s h a r i n g r i s k wi t h s ome c o s t s o f provi d i n g i n c en t i v e s t o t h e
a g e n t - - t he n e e d to c o n t ro l t h e a g en t • s c ho i ce o f effort .
The c o n d i t i o n ( 1 . 3 ) , wh i c h i s c a l l ed the i nc e n t i ve c o n s t ra i n t ,
can be s i mp l i f i e d to t h e s e t of e q u a t i o n s prov i de d by t he re l at i o n
shi p ( 1 . 4) .
Ho l ms trom ( 1 9 7 9 ) a n d M i r r l e s s ( 1 9 7 5 ) p o i n te d o u t a
s trong c o n d i t i o n t h a t s h ou l d be s a t i s f i e d for the s mo o t h t r a n s i t i on
from ( 1 . 3 ) to ( 1 . 4 ) .
The c ru c i a l a s s umpt i o n he re i s t h a t t h e f i r s t
a n d s e c o n d d er i v a t i v e s o f the p . d . f . fu n ct i o n f ( . ) wi t h re s pe c t t o
effort ex i s t .
I n dee d , i n s t a rt i n g o u r a s s umpt i o n s we were c a re f u l
to i nc l u d e t h i s c o n d i t i o n .
( See a s s umpt i on 6 . )
E s s e n t i a l l y , c o nd i
t i o n s ( 1 . 4 ) i mp l y t h e e x i s t e n c e o f a n o p t i mu m l ev e l o f e ffort , s i n c e
63
the d i s u t i l i ty o f effort i s a fun c t i o n o f the a g e n t ' s ex pect ed
u t i l i ty p rov i de d by the s h a ri n g ru l e .
An i n tere s t i ng po i nt i s the d e r i vat i on of the p ro ba b i l i ty
d i s t ri b ut i on fun c t i o n F ( X , e ) .
T h i s f u n c t i o n i s dete rmi ned j o i n t l y
by the de n s i ty funct i o n f ( w ) a n d t he f u n ct i on y ( X ,w ) .
For some
l ev e l of effort e , there i s a l way s a n outcome X wh i c h i s a s s o c i a te d
w i t h t h e p ro b a b i l i ty funct i o n o f the s t ate v a r i a b l e w , f ( w ) .
ou r c a s e X i s i n v a r i a n t to e .
In
Ge n e ra l l y , i nc re a s i n g e l e a d s to
" bette r '1 d i s t r i b u t i ons of f ( X , e ) .
T h i s impl i e s that the d i s tri bu
t i on r e su l t i n g from a h i g h e r v a l u e o f e i s a l way s p referred by the
pri nc i p a l to one re s u l t i n g from a l owe r va l ue o f e .
I t i s a l so
a s s umed t h a t the f ( X , e ) i s d i f fe re nt i a b l e to a ny d e s i ra b l e o r de r .
T h e l i t e ratu re rev i ew c o n d u c t e d i n sect i on I I revea l ed t h a t
t h e pri nc i pa l - a g e n t framewo r k a d d re s s es va r i o u s i s s ues of r i s k
s h a r i n g u n d e r a l te rnat i v e s pec i fi c a t i o n s o f e ffo rt .
T he i nt ro du ct i o n
of a n a dd i t i o n a l v a ri a b l e , i n ou r c a s e t he n a tu re o f c a s h fl ows
( d i v i s i on a l / a g g re g a te ) , a ugme n t s the s o l u t i ons t o t h e p ro b l e m .
Before we proceed wi t h the a l ternat i ve s pe c i fi c a t i o n s of ou r
mode l , we s h o u l d men t i on here the re s t r i ct i on s p l a c e d o n t h e s h a r i ng
ru l e .
More prec i s e l y , the req u i reme n t for a s o l u t i o n to the sys tem
of equ a t i on s ( 1 . 1 ) , ( 1 . 2 ) , a n d ( 1 . 3 ) i s t h a t the s h a r i n g ru l e s h ou l d
be res t r i cted to a n i n t e rv a l ( smi n , smax ) .
( H o l ms t rom ( 1 9 79 ) , p . 7 7 ) .
D i ffe re n t Spe c i f i c a t i on s o f Ef fort
O b s e rva b l e .
T he s o l u t i o n o f the sys tem o f equat i on s ( 1 . 1 ) a n d
( 1 . 2 ) p ro v i de s t h e f i r s t - b e s t s o l u t i o n u n d e r t h e a s sumpt i o n t h a t b o t h
64
the e ffo r t a n d the outc ome are o b s e rvab l e by the p r i n c i pa l wi t h o u t
mo ra l ha z a rd .
T h e f i r s t - b e s t s o l u t i o n i s u s e d f o r c ompa r i son p u r po s e s ;
i t re p re s e n t s a so l u t i on to a c omp l i ca t e d p r o b l em when i de a l con d i
t i o n s preva i l .
I f the a g e n t a n d pri n c i pa l a re r i s k n e u t ra l , the
l ev e l o f e ffort i s fou n d f rom the con d i t i o n t h a t e q u a t e s t h e ma rg i n a l
d i s u t i l i ty of eff o rt w i t h the ma rg i na l i nc re a s e i n the ex pected
out come .
The d e r i ved opt i ma l l e v e l o f e ffort e* , wh i c h i s ob s e rv a b l e
by a l l p a rt i e s i n v o l ved , i s u s e d t o determi ne t h e s h a r i n g ru l e .
Tab l e 2 g i v e s t he rewa rd s t ru c tu re fo r the a g e n t a n d t h e p r i nc i pa l
u n d e r d i ffe re n t p reference a s s u mpt i on s ( ri s k n e u t ra l i ty , r i s k
aver s i o n ) .
A con c l u s i o n from the a n a l y s i s i s t h a t i nt e re s t i n g
re s u l t s a re obta i n e d whe n bo th the a g e n t a n d t h e p r i nc i pa l h a v e
d i ffe rent r i s k a tt i tu de s ; one i s r i s k a v e r s e a n d the o t h e r i s r i s k
n e u t ra l .
I f b o t h the a g ent a n d the p r i n c i pa l a re r i s k a v e r s e , the
s h a r i ng ru l e i s the same e v e n though the d i v i s i o n a l ca s h fl ows a re
d i ffere n t , p rov i de d t h a t the a g g re g a te outpu t i s the s a me .
U n o b s e rv a b l e .
i st i c set t i n g .
The s e c o n d - b e s t s o l u t i o n p rov i de s a mo re rea l
I t a s s ume d t h a t t h e p r i n c i pa l i s n o t a b l e to detect
the l e ve l of effort t h a t the ma n a g e r p l a c e s i n each d i v i s i o n .
We can
exam i n e the p ro b l em under two d i ffe r e n t s e t s o f a s sumpt i on s reg a rd i ng
c a s h f l ows .
The f i rst a l t e rna t i ve i s to a n a l y ze the mo ra l e h a z a rd
p ro b l em when the p r i n c i pa l rece i ve s i n fo rma t i o n a b o u t the aggregate
l ev e l of c a s h f l ows .
A s e c o n d - b e s t s o l u t i o n i s fea s i b l e .
The second
65
Tabl e
2
F i r s t - Be s t So l u t i o n When Both E ffort and Outcome Are Known
R I S K NEUTRAL
The s h a r i ng ru l e i s deter
mi ned by the re l a t i o n s h i p :
df ( x , e )
de
R I S K NEUTRAL
ma rgi n a 1
i n crea s e
on e x p .
out come
Agent
R I S K AVERSE
dv
= _---"'"'"
de
_
_
R I S K AVERSE
Agent
: s ( x ) =x-k
Princi pal : x-s ( x ) = k
k
ma rg i n a l
d i s u t i l i ty
of e ffort
: fee pa i d to
the pri nc i pa l
: s ( x ) = H*+V ( e * )
Pri nc i pa l : x - s ( x )
P r i n c i p a l i s " fu l l y
i n s u red"
Agent
Agent
: s ( x )=1
Pri n c i pa l : x - s ( x ) = x - 1
: fee pa i d to the
1
agent
Age n t i s " fu l l y i n s u re d "
:s(x)
P r i nc i p a l : x - s ( x )
-------
��----�--- ----�- �
66
a l t e rn at i ve a l l ows for obs e rv a b i l i ty of d i v i s i on a l c a s h f l ows .
We
exam i ne c o n d i t i o n s u n d e r wh i c h a dd i t i on a l i n f o rmat i o n a b o u t d i v i s i on a l
ou t pu t i s a v a l u a b l e a n d i n forma t i v e s i g na l .
Ca s e # 1 :
Effort i s u n o b s e rv a b l e but the a g g re g a t e c a s h f l ow
i s o b s e rv a b l e by the pri nc i pa l .
We can de ri ve t h e s e c o n d - be s t
s o l u t i o n o n l y u n d e r res t r i c t i v e a s s u mpt i o n s p l a c e d o n p re fe rence s .
We a s s ume a r i s k - n e u tra l p r i n c i pa l a n d a r i s k - a v e r s e a g en t .
In
a d d i t i o n , we a s sume an HARA u t i l i ty f u n c t i o n fo r the a g e n t .
The
der i v ed s h a r i ng ru l e i n d i c a t e s t h a t the agen t i s c ompen s a t e d a c c o rd i n g
to the o u t p u t p roduced .
For expos i t i on a l p u rp o s e s , we pro v i de the
s ha r i ng ru l e when the f ( . ) i s a p . d . f . whi c h bel o n g s to t h e fami l y
o f no rma l d i s tr i bu t i o n s .
Therefore , o u r a p p roa c h a n a l yz e s t h e
func t i o n a l re l a t i o n s h i p betwe e n d i v i s i on a l e ffort , s h a r i ng r u l e s ,
a n d a g g re g a t e c a s h fl ows .
We u s e t h e l og ( x ) funct i o n to d e s cr i be the a g e n t ' s prefe ren c es .
T h i s f u n c ti on i s de r i ved from the g e n e r a l HARA u t i l i ty func t i o n :
U(x)
=
1 -y
y
[�
1 -y
+
n
]
Y
(2 . 1 )
S > O , y :f 1
( 2 . 2)
For
y
=
0, we o b ta i n
U(x)
=
l og x
( 3)
From the equ a t i o n s ( 1 . 1 ) , ( 1 . 2 ) a n d ( 1 . 4 ) we obta i n the fo l l ow i n g
formu l a t i o n :
67
�(\
s . t.
e
J
J[
G ( x- s ( x ) ) + A · U ( s ( x ) )
U ( s ( x ) ) f ( x , e ) dx =
]
av . ( e )
�
i
•
f ( x , e ) dx
Y
i
= 1 ,2, . . . .n
(4)
(5)
The s o l u t i on o f a bove sys tem o f equa t i o n s i s prov i de d i n t h e re l a t i o n
(6) .
If
A t 0 and v t 0 , Vi
i
1 , 2 , . . . n we obta i n
(6)
where :
A a n d v . ' s a re the La g ra n g i an mu l t i p l i e rs fo r t he re l a t i on s
1
( 1 . 2) and ( 1 .4)
s (x )
i s t he s ha r i n g r u l e .
I t i s g i v en t h a t s ( x ) = [ s m ' s
ax mi n ]
n i s a n i ndex i nd i ca t i n g d i v i s i on
af( x ,e ,e2 ' ' ' e n )
1
ae .
=
I t i s a s s umed t h a t
1
From ( 6 ) a n d
G ' [ · ] = 1 we h a ve :
1
= A +
U ' [s ( x ) ]
�
v ; f; ( x , e l , e2 ' ' ' ' en )
f(x ,e ,e2 , . . . e )
n
1
(7)
Cons i de r i n g ( 3 ) a n d ( 7 ) we rece i ve :
n
s(x) = A +
L v ; fi ( x , e 1 , e2 , . . . en )
f( x , e , e 2 , . . . e )
1
n
(8)
68
For a n o n - de c rea s i n g s ha r i n g ru l e the fo l l ow i n g c on d i t i on s ho u l d be
sat i sfi ed :
a
ax
[
(x ;e )
f(x ;e )
f
i
]
>
0
Vi
1,2, . . .n
=
Be l ow we exam i ne the c a s e o f n o rma l proba b i l i ty d i s t r i but i on fun c t i o n .
I t i s a s s ume d t ha t :
( 9)
where :
f( x ;e )
=
af(x ;e )
a (x ;e)
=
M(e )
x 1.
=
=
1
.[2:
--=
==
=-
M'
(�)
a
exp
[
-
( x-M( e ) ) 2
2
20
]
[x-M ( e ) ]
i s t he s umma t i on o f e fforts
i s t he d i v i s i o n a l c a s h fl ow
From ( 8 ) , ( 9 ) a n d ( 1 0 ) we ha v e :
( lOa )
( lOb)
69
Ano t h e r e x p re s s i o n o f ( 1 1 )
is
s (x )
or
S(X)
=
1:;
l/JX
+
The l a s t re l a t i o n s h i p s hows t h a t the s ha r i n g ru l e depen d s d i re c t l y on
the o u t p u t pro d u c e d .
Th i s i n tu i t i v e re s u l t wa s o b ta i ne d u n der t he
re s t r i c t i v e a s s umpt i on s o f n o rma l p . d . f . o f x ' s a n d l o g a r i t hm i c
i
u t i l i ty fun c t i on .
I n the next s e ct i o n we s h i ft o u r i nt e re s t i n top i c s o f d i s a g grega t i on o f i n fo rma t i on by d i s c u s s i n g t h e c o nd i t i o n s u n d e r wh i c h
the p r i nc i pa l w i l l be better off know i n g ea c h d i v i s i o n a l c a s h f l ow
rather t h a n the a g g regate c a s h f l ow .
Case #2 :
are o b s e rv a b l e .
Effort i s u n o b s e rv a b l e but the d i v i s i o n a l c a s h f l ows
We addre s s two i s s ue s .
Fi r s t , we exam i n e whether
or not a d d i t i o n a l i n forma t i o n about d i v i s i o na l c a s h f l ows i s a
v a l u a b l e s i g n a l for the p r i n c i pa l .
L emma I w i l l a d d re s s t h i s i s s u e .
Thi s p ro b l em i s re l a ted to t h e c o n trove r s i a l i s s u e o f report i ng
se gme n te d f i n a n c i a l i n fo rma t i o n .
I n t h e pa s t , t h e S . E . C . h a s
req u i red t h a t bu s i n e s s f i rms report i n fo rma t i on a c c o rd i n g to the i r
p ro d u c t l i ne c l a s s i f i ca t i o n s .
R e s e a r c h on the emp i r i c a l fro nt h a s
s hown t h e u s e fu l n e s s of report i n g i n fo rma t i o n o f d i ffe re n t p rod u c t
70
l i n e s o f a n e n t i ty , wh i c h a l s o h a s we l fare i mp l i c a t i o n s .
For examp l e ,
Col l i n s ( 1 9 7 5 ) a r g u e s t h a t s e gme n t reve n u e data c a n be u s e d to s u c
ces s fu l l y a n t i c i pate c h a n g e s i n t h e tota l e a rn i n g s o f a n e n t i ty
whi c h wou l d be o t h e rwi s e 11 U n e x pe c te d 11 i f on l y c o n s o l i dated data we re
avai l abl e .
An i mportant i m p l i c a t i o n i s that the effi c i e n cy o f the
c a p i ta l ma r kets co u l d be i mproved w i t h the re l e a s e o f more p rec i s e
a n d a c c u rate f i n a n c i a l data .
W i t h L emma I we prove t h a t a d d i t i ona l
i n fo rma t i o n i s o f v a l u e to t h e p r i n c i pa l .
A s e c o n d i s s u e o f i mporta n c e i s the a g g re g a t i o n o f the
s ha r i ng ru l e s .
I f a d d i t i o n a l i n fo rma t i on a b o u t d i v i s i on a l c a s h
fl ows i s prov i de d , w e exam i ne how t h e s h a r i ng ru l e s ho u l d be
determ i n e d .
P ro p o s i t i o n I a d d re s s e s the qu e s t i o n o f compe n s a t i ng
the agent o n the bas i s o f d i s a g g re g a te d o u t pu t .
v i ta l i mporta nce f o r the p r i nc i p a l .
Th i s i s s ue i s o f
A s h a r i n g ru l e ba s e d o n
a g g regate o u tc ome s h ou l d be compa red t o the s h a r i n g ru l e o b ta i ne d
u n d e r t h e a s s ump t i o n of d i v i s i o n a l pe rforma n c e .
D.
A L emma a n d A Pro po s i t i o n
L emma I r e l i e s o n Ho l ms trom ' s ( 1 9 7 9 ) i n terp reta t i o n o f t h e
not i on o f a v a l u a b l e s i g n a l .
T o i mp ro v e the c o n t ra c tu a l a rrangement
betwee n t h e p r i n c i p a l and the a g en t , i n a dd i t i o n to the o b s e rved
parame ter X , a s i g n a l c a n be u s e d .
More s pe c i f i c a l l y , a s i g n a l x '
i s c on s i dered a s v a l u a b l e i f the c o n t ra c t s ( X , x ' ) i s s u pe r i o r
to s ( X ) .
To determ i ne the s ha r i ng ru l e s ( X , x ' ) , x ' i s trea ted a s
a s ta te v a r i a b l e .
The func t i o n f ( X , x ' ) g i ve s the j o i n t p ro ba b i l i ty
-- - --------------------
71
o f X a n d X 1 g i ven e ( =e 1 , e 2 , e 3 . . . e n ) .
Aga i n the p r i n c i pa l 1 s
pro b l em i s to max i m i z e a t e a c h pa i r o f va l u e s ( X , x 1 ) t h e s h a r i n g
ru l e s ( X , x 1 ) .
G1 ( . ) _
� -
W e obta i n a n expre s s i o n s i mi l a r t o ( 8 )
A + �
fe ( X , x I , e )
f( X , x 1 , e )
Now fe/ f va r i e s w i t h X 1 a n d t h e s h a r i n g ru l e wi l l b e mod i f i e d i n
l i g h t o f t h e o b s e rv a t i o n of X 1 •
Howe ve r , o b s e rva t i o n X 1 i s a
v a l u a b l e s i g n a l o n l y when :
fe ( X , x 1 , e )
t- h ( X , e ) '
f(X ,x 1 ,e)
( X ,x 1 ) ,h( . )>0
Not i ce t h a t the r i g h t h a n d s i de o f the a bove e qu a t i o n doe s n o t
c o n ta i n t h e pa rame ter X 1 •
By s o l v i n g the d i ffe re n t i a l e q u a t i on we
rece i ve an e q u i va l e n t expre s s i o n :
f ( X , x 1 ; e ) t- g ( X , x 1 ) * h ( X , e ) , for every ( X , x 1 )
where g ( . ) , h ( . ) > O .
( P roof ( n o t i n c l u d e d i n Ho l m s t rom ( 1 9 7 9 ) ) :
fe ( X ; e ) = J fe ( X , x 1 , e ) dx 1 = h e ( X ; e ) J g ( X , x 1 ) dx 1
f(X;e) =
J f ( X , x 1 ; e ) dx 1 = h ( x ; e ) J g ( X , x 1 ) dx 1
=>
fe
t- h ( x , e )
f
Now we forma l l y s ta te o u r l emma :
L EMMA I
The d i s a g g rega t i o n o f o u t p u t i s a va l u a b l e s i gn a l .
L e t u s a s s ume t h a t the d i s a g g re ga t i o n o f the o u t p u t i s g i ven
by X 1 = ( x , x 2 , . . x ) .
n
1
The s i gn a l X 1 i s v a l u a b l e and i n fo rma t i ve i f :
72
f ( X -, x 1 e ) r g ( X , x 1 ) * h ( X , e ) , fo r every ( X , x 1 )
( 12)
where g ( . ) , h ( . ) > 0
Proof :
We prove P ropos i t i o n I by con trad i c t i o n .
re l a t i on ( 1 2 ) h o l d s i n equ a l i ty fo rm .
A s s ume t h a t the
Accord i n g to H o l mst rom ( 1 9 7 9 )
t h i s i mp l i e s t h a t X i s t h e s u ffi c i e n t s t a t i s t i c o f the ( X , X 1 ) w i t h
respect to e , wh i c h me a n s t h a t X c a r r i e s a l l the re l e v a n t i n forma t i o n
a b o u t e a n d x 1 , a n d 1 1 a d d s noth i n g t o the powe r o f i n feren c e . 11
Howe ve r , the d i me n s i o n o f X i s 1 w h i l e the d i me n s i o n o f X 1 i s n .
S i nce the d i me n s i o n s of X a n d X 1 d i ffe r , i t i s i mpo s s i b l e t h a t X
i s a s u ffi c i e n t s ta t i s t i c for the pa i r o f ( X , X 1 ) .
The refore , we conc l ude t h a t X i s not s u ff i c i e n t s ta t i s t i c
o f the pa i r of ( X , x 1 ) w . r . t . e , a n d t h a t rel a t i o n s h i p ( 1 2 ) i s v a l i d .
T h i s mea n s t h a t the d i s s a g rega t i o n of d i v i s i o na l c a s h f l ows i s a
v a l u a b l e a n d i n fo rma t i ve s i gna l .
Di scu s s i on :
A l t h o u g h L emma I h a s an i n t u i t i ve a p pe a l , we s h o u l d e x p l a i n
why s pe c i f i c i n forma t i o n a b o u t d i v i s i o n a l c a s h f l ows i mp ro v e s r i s k
betwee n t h e p r i nc i p a l a n d t h e a g e n t .
A c o n t r a c t between t h e p r i n c i pa l a n d a g e n t s h ou l d i n c l ude
s ome i n cen t i ve e l ements that are des i g n e d to mo t i vate the a g e n t
to perfo rm t h e a g reed e ffort e v e n u n d e r con d i t i o n s o f u n c e r t a i n ty
( fo r more d i s c u s s i o n on the ra t i o n a l e fo r i n c en t i v e s a n d a l tern a t i ve
forms o f i nc e n t i v e s p l e a s e refer to s e c t i on I l i a ) .
The e s s en t i a l
73
reason of i nc o rpora t i ng the d i v i s i o n a l c a s h f l ows i n to the c on t rac t
i s n o t the need for a dd i t i o n a l i n forma t i on regard i n g t h e u n o b s e rv a b l e
e ffo rt , but ra t h e r i s the need o f p ro v i d i ng addi tional incen t ives
the a g en t .
to
The a g e n t i s g i v e n an i n d i rect way of increas ing his value
of effort wh i c h i s e x pe n ded to v a r i ou s d i v i s i o ns .
I n s i m i l a r t e rms ,
a dd i t i o n a l i n fo rma t i o n a bou t d i v i s i o na l c a s h f l ows re d u c e s the
p r i n c i pa l 1 s cos t o f p ro v i d i ng the a g e n t w i th the r i g h t k i nd of
i nc e n t i ves .
Anothe r way to e x p l a i n the i n c e n t i ve a s pe c t s of p rov i d i n g
i n fo rma t i on a bou t d i s a g g re g a te d c a s h f l ows i s by l oo k i n g at the
f ( X , e ) , the j o i nt d i s tr i bu t i on o f X , e .
A con t ra c t t h a t depends
o n l y on a g g re g a te d cash fl ows X c reates amb i g u i ty w i t h re s pe c t to
a fa i r comp e n s a t i o n o f the a g e n t .
1 ead
A h i g h o b s e rved va l ue o f X w i l l
to a high payme n t to the a g en t , e ven t h o u g h the e ffort
expended i s low .
S i m i l a r l y , a l ow o b s e rved v a l u e o f X w i l l resu l t
to a v e ry l ow payment to t h e a g e n t , e v e n when t h e a g e n t c ho s e s a
h i g h e f fo r t .
A c o n t ract ba s e d on a g gregated c a s h f l ows a l o ne , i . e . ,
a c o n t r a c t o f the s ( X ) fo rm , i mp l i e s a c ompen s a t i on wh i c h c a n not
s e pa rate s tate u n c e r ta i n ty from effo r t .
I t i s p o s s i b l e t ha t th i s
s i tu a t i o n i s undes i ra b l e from the p r i n c i pa l 1 S po i n t o f v i ew .
I f a d d i t i on a l i n forma t i on ab ou t the c ompo nents o f a g g re g a t e d
c a s h fl ow i s prov i ded , t h a t i s , i n fo rma t i on a bo u t the d i s a g g rega
t i o n o f the o u t pu t , i t bec ome s l e s s u n l i ke l y t h a t h i g h v a l u e s of
bo t h the X and X 1 wo u l d be o b s erved when i n fac t effort i s very
l ow .
S i m i l a r l y , i t i s i mp l a u s i b l e t h a t l ow v a l ues of both X a n d
------·-·---·-·-·--·--------------
74
x • wou l d be o b s e rved wh e n i n fact e ffo r t i s h i g h .
The refore ,
i nc or p o r a ti n g i nfo rma t i o n a b o u t d i v i s i on a l c a s h f l ows i n to the
c o n t ract reduc e s the c h a n c e o f re warding the a gen t for the wron g
reason .
O r , equ i v a l ent l y , t h e p r i n c i pa l can s u b s t a n t i a l l y reduce
the pas s i b i l i t i es of ei ther w ron gly re warding low efforL o r
wrong ly penalizing high effort.
From a ra t i ona l po i n t of v i ew ,
the i nc l u s i o n of d i v i s i o n a l c a s h fl ows i n to the c o n t r a c t pro tec t s
the a g e n t ' s i n tere s t s .
W h i l e L emma I h i g h l i g h t s the i mportance o f the d i s a gg re g a te d
i n forma t i o n , propos i t i o n I e n h a n c es the a n a l ys i s by i n v e s t i g at i ng
the c ompa t i b i l i ty of the s h a r i ng r u l es der i ve d u n d e r the c o n d i t i o n s
of d i s a g g re g a ted a n d d i v i s i on a l i nf o rma t i o n .
P ro po s i t i on I
I n a mu l t i d i v i s i o n a l f i rm s h a r i ng ru l e s b a s e d on a g g rega te
c a s h f l ows a r e d i ffe ren t from s h a r i ng ru l e s wh i c h are b a s e d o n
d i v i s i on a l c a s h f l ow s .
Th i s i mp l i e s t h a t i f the p r i nc i p a l observes
the v e c t o r x ' ( x , x , . . x ) ' ra t h e r than the f i g u re X ( X=x 1 +x 2 . . + x n ) '
2
1
n
the s h a r i ng ru l e s x { x ' ) a n d x { X ) sa t i s fy the re l a t i on s h i p :
s(x' ) � s(X)
{ 13}
P roof :
L e t u s a s s ume t h a t the pri n c i pa l can o b s e r v e the d i s a g g r e ga t i o n
o f c a s h f l ows x ' = ( x p x , . . . x } .
2
n
The j o i n t d e n s i ty fu n c t i o n o f x •
75
and a l l t he e ffo rts e , e , . . . e i s g i ven by f ( x , x , . . . x ; e , e , . . . e )
1 2
n
n
1 2
n 1 2
or f ( x ' ;e 1 ,e , . . . e ) .
2
n
1
U ' [ s ( x )]
where :
We c a n o b ta i n s i m i l a r res u l ts to re l a t i o n [ 8 ] :
(1 4 )
=
f ( · ) i s the p . d . f . w i t h s i mi l a r a s s umpt i o n s to o u r a s s umpt i o n 6 .
To s i m p l i fy o u r proof we a s s ume :
1.
A mul t i v a r i a te no rma l proba b i l i ty d i s tr i b u t i o n for the f ( · )
fun c t i o n
2.
The a g e n t h a s a l o g a r i thmi c u t i l i ty funct i on
3.
T h e re a re two d i v i s i o n s , n
=
2 , w i t h c a s h fl ows x
1
and x .
2
Ca s h f l ows a re re l a te d w i t h a c o r re l a t i on p
Therefore , we h a v e :
x'
A
=
=
( x ,x ) - N( e , A)
1 2
[
p:
01
2
p cr 1 cr 2
J
p o- 1 ° 2
cr 2 2
c o r re l a t i o n coeff i c i e n t
s ta n da rd de v i a t i on s
A:
c o v a r i ance ma tr i x
( 15)
76
A l s o w e know t h a t :
( 1 6)
We de f i ne :
f (.)
1
f2 ( . )
=
=
af
( x ' ; e , e2 ' . . . e )
1
n
ae
1
af
( x ' ; e , e2 , . . . e )
1
n
ae2
From ( 1 6) we obta i n :
For d i v i s i o n 1 :
For d i v i s i o n 2 :
f (x l 'x2 )
1
f2 ( x l ' x 2 )
=
( x -e )
1 1
2
( 1 -p )
(J
/
( x 2 -e 2 )
2
2
(J
2 ( 1-p )
Comb i n i n g ( 1 3 ) , ( 1 5 ) a n d ( 1 6 ) we rece i v e :
( x2-e2 )
2
cr 1 cr 2 ( 1 - P )
( x -e l )
1
2
0 °2 ( 1-p )
1
( 17 )
-- ---------
1
S (X )
I f ca s h f l ows x
s (x ' )
=
A +
Al s o , for n
1
a n d x 2 a re i n depende n t ,
p
=
0 and ( 18 ) yi e l ds
c:� c:�) { :1) { :�)
xl
=
+
x2
-
·
0
-
·
a
( 19]
2 ( E q u at i o n 1 1 ) y i e l d :
( 20 )
A s i mp l e compa r i s o n of t he s ha r i n g ru l e s de r i v e d i n re l a t i o n s ( 2 0 )
a n d ( 1 9 ) l ea d s to the con c l u s i on t h a t genera l l y :
( 13)
s (x ' ) � s (X)
An i n teres t i n g que s t i on a r i s e s wi th res pect to the d i re c t i o n of t h e
i ne q u a l i ty of ( 1 3 ) , that i s , i s i t true that s ( x ' )
<
s (X) .
>
s ( X ) or s ( x ' )
Unfortu n a te l y , o u r a n a l y s i s pro v i des a n amb i g u o u s a n swe r .
- -- ---78
By s u btra c t i n g ( 20 ) from ( 1 9 ) we obta i n :
s(x' ) - s(X)
(21 )
1
S(X )
2
I t 1. s tru e t h a t 0
1
<
01
2
+ 02
2
=)
_1_
1 > -:!:...2
2
2
0 1 +0 2
01
However , the s i gn o f the terms i n s i de the bra c ke t s i s u n c l e a r .
We c a n
prove t h a t s ( x ' ) > s ( x ) o n l y u n de r the fo l l ow i n g s tr i c t co n d i t i o n s :
(a)
( x 1>e 1 ) and ( x2>e2 )
2
> j.J 0
2 1
(b)
j.J 1 ° 2
(c)
).J l , ).J 2 > 0
2
or
2>
j.J 2
(G_l_ )
2
°2
( 22 )
A l l three c o n d i t i o n s s h o u l d be s a t i s f i e d s i mu l taneo u s l y .
Al t h o u g h the s e t o f con d i t i on s ( a ) i s rea son a b l e , c on d i t i o n s ( b )
i mp o s e a p ro b l em wi th re s pe c t to t h e i n te r preta t i o n o f the resu l t s
obta i n e d .
79
Ano t h e r p ro b l em o f re l a te d i n te re s t i s the s e a r c h for the
neces s a ry c on d i t i on s fo r the e q u a l i ty o f ( 2 1 ) .
cond i t i on s s i m i l a r to ( 2 2 ) c a n be de r i ved .
I t t u r n s o u t that
T he s e a re
(bI )
Howe ve r , c o n d i t i on s
( a ' ) a re u n re a l i s t i c .
Di scus s i on :
I n g e n e ra l , a contract be tween the p r i n c i pa l a n d t h e a g e n t
c a l l s f o r a h i g h e r paymen t a t a re l a t i ve l y h i g h va l u e s o f a g gregated
cash f l ows and a l ower payme n t a t re l a t i v e l y l ow v a l u e s o f aggregated c a s h fl ow .
To the extent t h a t t h e a g e n t a l l o c a t e s h i s effort
c o rre c t l y among d i v i s i o n s th i s a p proach i s a c c e p ta b l e .
s i nce effort i s u n o b s erva b l e t h e re a re two i s s u e s :
Howeve r ,
f i r s t , the
prob l em of m i s a l l oc a t i o n of e ffort ; a n d seco n d , the i s s ue o f the
pro p e r i n c en t i v e s to the a g en t .
M i s a l l oc a t i o n o f e ffort
The a g e n t can a l l o c a te h i s effo r t to d i v i s i o n s wh i c h are
c h a ra c te r i zed by h i g he r ma rg i n a l produ c t i v i ty o f effort or by l owe r
ma rg i na l d i s u t i l i ty of effort .
I t i s i n t h e be s t i n te re s t o f the
a g e n t t o e x pe n d e ffort to t h o s e d i v i s i o n s t h a t e x h i b i t h i g he r
produ c t i v i ty s i nc e the f i n a l c ompe n s a t i o n d e p e n d s u pon t h e a g g re g a te
80
c a s h f l ow .
Th i s be h a v i or can c re a te a c ro s s - s u b s t i tu t i o n o f efforts
amo ng d i ffe re n t d i v i s i on s a n d fa i l s to d i s t i n g u i s h i n te n t i on a l
behav i or for h i g h e r s ha re o f the f i n a l o u tcome from true e ffort
expended to d i v i s i o n s .
A way o u t o f th i s prob l em i s to requ i re the
a ge n t to re port d i v i s i o na l c a s h f l ows rather t h a n a g g re g a t e f i g u re s .
To the e x t e n t t h a t d i v i s i on a l e ffort a n d d i v i s i ona l c a s h f l ows a re
corre l a te d , the p ro b l em o f effort m i s a l l oca t i on c a n be re d u c e d .
I s s ue s o f i n c e n t i v e s
T h e e s s e n t i a l re a s o n f o r i n c o r po ra t i n g d i v i s i o n a l c a s h f l ows
i n to the s h a r i n g ru l e i s to prov i de the a g e n t - - i n a d i s c r i m i nat i ng
ma n n e r - - a n a dd i t i o n a l i nc e n t i ve to i n c r e a s e h i s v a l u e o f e ffort .
A c o n t r a c t t h a t d e p e n ds o n a g g re ga te c a s h fl ow a l one doe s not t a k e
i n to c o n s i dera t i o n t h e d i v i s i o n a l u n c e r ta i n t i e s .
A l ow a g g re g a te
c a s h f l ow o b s erved i mp l i e s a l ow compe n s a t i on to the a g e n t even
t h rou g h h i s effort p l aced on s e v e r a l d i v i s i o n s wa s h i g h .
To a v o i d
t h i s i s s ue the a g e n t s h ou l d offer a n i n c e n t i ve to the ma n a g e r by
s pe c i fy i n g a c o n t r a c t a c c o rd i ng to d i v i s i on a l c a s h f l ows .
As a
f i n a l re s u l t the a g e n t i s c ompen s a t e d i n a fa i r ma n ne r .
The a bo v e d i s c u s s i on h i g h l i g h t s a n i mporta n t i s s u e i n des i g n i n g
a c o n t ra c t , name l y the i s s u e of effi c i e n cy o f t h e s h a r i n g ru l e .
The
p r i n c i pa l i s c o n c e rn e d wi t h a n effi c i en t way o f compe n s a t i ng the
a gen t .
S i nce the a g e n t can rea l l o c a te h i s effort i n d i v i s i on s for
wh i c h h i s marg i n a l d i s u t i l i ty o f effort i s mi n i ma l , the prob l em o f
the a g e n t • s c ompe n s a t i o n i s c omp l i c a te d c on s i dera b l y .
For c ontro l
81
purposes t h e p r i nc i pa l s h ou l d re q u i re the a g e n t t o report d i v i s i on a l
c a s h f l ow s .
Howe v e r , i t i s n o t c l e a r i f the pr i nc i p a l ' s s h a re of
the f i n a l o u tc ome i n c re a s e s w i t h th i s a rrangeme n t .
O n one hand ,
a c o n t r a c t b a s e d o n d i v i s i ona l c a s h f l ows reduces the a g e n t ' s mot i va
t i o n t o a l l o c a te e ffort i n d i v i s i on s t h a t m i n i m i ze h i s d i s u t i l i ty
o f e ffort .
On the o t h e r h a n d , c ompe n s a t i n g agents a c c o rd i n g to
d i v i s i on a l cash f l ows does not rea l l y a l l ow for the fu l l e x p l o i ta t i o n
o f t h e mana g e r ' s ma rg i n a l produc t i v i ty of effort .
Howeve r , what
i s c l e a r i s that s h a r i n g r u l e s ba s e d o n a g g rega te c a s h f l ows are
d i f fe r e n t from those wh i ch a re based o n d i v i s i o n a l c a s h f l ows .
IV.
CONCL U S I ONS
T h e foc u s o f th i s e s s ay has been o n the a pp l i c a ti o n of the
r i s k- s h a r i n g a g e n cy mode l to a mu l t i di v i s i on a l s t ru c t u re .
At t he
be g i n n i n g o f t h e pape r we prov i de d a taxonomy o f f i rms ba s e d on two
d i s t i n c t d i mens i o n s :
t h e type of i n terna l o r g a n i z a t i o n a l s t ru c tu re ;
and t h e s c o pe of ana l yz i ng the a g e n cy prob l em .
Ou r emph a s i s wa s
on the i mpa c t o f i nforma t i o n reg a r d i ng a g g re g a te o r d i v i s i o n a l c a s h
fl ows on t h e s h a r i ng ru l e s betwe e n t h e pri nc i pa l a n d t he a g e n t .
Ou r
a n a l y s i s i n d i ca t e s t h a t i n fo rma t i o n r e g a r d i n g d i v i s i o n a l performa nce
i s h e l p f u l i n a s s e s s i ng the a g en t ' s c ompens a t i on .
Co n t ra c t u a l a rra n geme n t s c a n not e l i m i n a te p ro b l ems o f i n fo rma
t i o n a l a symme t ry reg a rd i ng effort f rom the p r i n c i pa l
1S
po i n t o f v i ew .
I f effort i s a n u no bservab l e v a r i a b l e d i v i s i o na l performa nce c a n
b e u s e d a s a v a l u a b l e , a l t h o u g h i mp e r fect , s i g n a l t o i mprove the
��--�--�
� -----
--
82
r i s k s h a r i n g be tween the pa rt i e s i n vol ved i n a c o n t ra c t .
The cen tra l
hypo t h e s i s o f o u r a n a l ys i s c o n c e r n s the s h a r i ng ru l e s of a g g re g a t e d
o r d i v i s i o n a l c a s h fl ows .
Certa i n l y , the p r i n c i pa l regards t h e
d i s a g g re g a t i o n o f c a s h fl ows a s a de s i ra b l e v a l u a b l e s i g n a l .
Some l i m i ta t i o n s o f o u r a n a l y s i s were d i s c u s s e d i n s e c t i on
III.
Howe ve r , o u r framewo r k c a n be e x t e n de d to t h e d i re c t i on t h a t
wi l l a l l ow u s to deri ve t h e o p t i mum amo u n t of e ffo rt a l l o c a t e d by
the a g e n t to d i fferent d i v i s i on s .
PART I I
B I BL I O GRAPHY
84
B I BL I OGRAPHY
Armo u r , H . , and D. Teece , 1 9 7 8 , Organ i z a t i ona l s t r u c t u re and economi c
perfo rma n ce : A tes t o f the mu l t i d i v i s i o na l hy pothe s i s , The B e l l
J o u r n a l o f Econom i c s 9 ( 1 ) , 1 06- 1 2 2 .
Arrow , K . , 1 9 7 4 , L i mi ts to o r g a n i z a t i o n s , New Y o r k : Norton Co .
C h a n d l e r , A l fred D . , 19 7 7 , The v i s i b l e hand : The ma n a g e r i a l rev o l u
t i o n i n ame r i c a n bus i ne s s , Cambr i dge , MA : Harv a rd Un i v e rs i ty Pres s .
C o l l i n s , W . O . , 1 9 8 1 , SEC prod u c t l i n e report i n g a n d mar ket e ff i c i e n cy ,
J o u r n a l o f F i n a n c i a l Econom i c s , 1 06- 122 .
Fama , E . , 1980 ( Apr i l ) , Agen cy probl ems a n d t h e theory o f t h e f i rm ,
J o u r n a l o f P o l i t i c a l Economy 88 , 2 88-307 .
Fama , E . , a n d M . J e n s e n , 1 983 ( J u ne ) , Separa t i o n of owne rs h i p a n d c o n
tro l , J o u r n a l o f L a w a n d Economi c s 2 6 , 3 0 1 - 3 2 5 .
Fama , E . , a n d M . J e n s en , 1983 ( J u n e ) , Agency pro b l ems an d res i d u a l
c l a i ms , J o u r n a l o f Law a n d Econom i c s 2 5 , 3 2 7 - 349 .
Fama , E . , a n d M . Jen s en , 1985 , Res i du a l c l a i ms a n d i nv e s tment dec i
s i on s , J o u r n a l o f F i n a n c i a l Economi c s 1 4 , 1 0 1 - 1 2 0 .
Gro s sma n , S . J . , a n d 0 . 0 . Hart , 1983 , An ana l y s i s o f t h e p r i n c i pa l
a g e n t pro b l em , Econome t r i c a 5 1 ( 1 ) , 7 -4 5 .
Har r i s , M . , a n d A . Ra v i v , 1 9 7 8 ( Ma rch ) , Some res u l t s o n i n c e n t i v e
c on t r a c t s , Economi c Re v i ew 68 ( 1 ) , 2 0-30 .
H a r r i s , M . , a n d A . R a v i v , 1 97 9 , O pt i ma l i nc e nt i v e s c o n t r a c t s , The J o u r
na l o f Economi c Theory 2 0 , 2 3 1 - 2 5 9 .
Hol ms trom , B . , 1 9 7 9 ( Spri n g ) , Moral h a z a rd a n d o b s e rv a b i l i ty , The B e l l
J o u r n a l o f Economi c s 1 0 , 7 4- 9 1 .
Ho l ms t rom , B . , 1 982 ( Au tumn ) , Moral h a z a r d i n teams , The B e l l J o u rna l o f
Econom i c s 1 3 , 324-340 .
J e n s e n , M . , 1 984 , Corpo ra t e c o n t r o l : Fo l k l o re v s . s c i e n c e , Wo r k i n g
p a p e r , M E R C 1984-04 , ( U n i v e rs i ty o f Roc h e s t e r ) .
J e n se n , M . , a n d W . Mec k l i n g , 1 9 7 6 ( October ) , Theory of t h e f i rm : Ma n a
g e r i a l behav i o r , a g en cy c o s t s a n d c a p i ta l s t r u c t u re , J o u r n a l o f
F i n a n c i a l Econom i c s 3 , 1 30- 1 6 3 .
85
J e n s e n , M . , a n d R . Ruba c k , 1983 , T h e ma r k et fo r c o rporate c o n t r o l :
The s c i e n t i f i c e v i dence , The J o u rna l of F i n a n c i a l Econom i c s 1 1 ,
5-50.
Leftw i c h , R . , 1 9 8 1 ( Ma rc h ) , Ev i dence of t he i mpact o f ma n d a t o ry c ha n g es
i n a c c ou n t i ng p r i nc i p l e s on c o rporate l oa n a g reeme n t s , J o u r n a l of
Ac c ou n t i n g a n d Econom i c s 4 , 3-36 .
Leftw i c h , R . , 1983 ( J a n u a ry ) , Ac c ou n t i n g i n fo rma t i o n i n p r i v a te ma r
kets : Ev i dence from pri vate l en d i ng a g reeme n t s , The Accou n t i n g
Rev i ew 99 , 1 6 1 - 1 7 2 .
M i r r l ees , J . , 1 976 ( Sp r i n g ) , T he o p t i ma l s t ruc ture o f i n c e n t i ve s a n d
a u t ho r i ty w i t h i n a n organ i z a t i on , T h e Be l l J o u r n a l o f Econom i c s 7
( 1 ) , 1 03- 137 .
Moo k herj e e , D . , 1 983 ( Ma rc h ) , O p t i ma l i ncen t i v e s c hemes i n mu l ti a ge n t
s i t u a t i o n s , Wo r k i n g paper ( Lo n do n S c oo l o f Economi c s ) .
Mye r s , S . , 1 9 7 7 ( No v embe r ) , Determi n a n ts of c o r po rate b o r ro w i ng , Jou r
n a l o f F i n a n c i a l Econom i cs 4 , 147- 1 7 5 .
Ros s , S . , 1 9 7 3 ( May ) , The econom i c t heory o f a g e n cy : The p r i nc i pa l • s
probl em , Ame r i can Econom i c Re v i ew L X I I , 1 3 4- 1 3 9 .
S ap p i n g ton , D . , 1983 , L i mi te d l i a b i l i ty contracts betwe e n pr i nc i pa l
a n d a ge n t , J o u r n a l o f Econom i c Theory 29 , 1 - 2 1 .
Sapp i ngton , D . , a n d J . Dems k i , 1983 , Mu l t i a g e n t c o n t r o l i n perfe c t l y
corre l a te d e n v i ronme n t s , Economi c Letters 1 3 , 3 2 5 - 3 3 0 .
S h a v e l l , S . , 1 9 7 9 ( Sp ri n g ) , R i s k s h a r i ng a n d i n ce n t i ves i n t he p r i n
c i p a l a n d a g e n t re l a t i o n s h i p , T h e Be l l Jou rna l of Economi c s 1 0 ,
55-73 .
St i g l i tz , J o s e p h , 1 9 7 5 ( Autumn ) , I nc e n t i ves , r i s k a n d i n forma t i on :
Notes towa rd a theory o f h i e r a r c hy , The Be l l Jou rna l of Econom i c s
6 ( 2 ) , 5 52 - 5 7 9 .
Smi t h , C . , a n d J . Warne r , 1 9 7 9 ( J u l y ) , O n f i n a nc i a l c on t r a c t i n g : An
a n a l ys i s of bond covena n t s , Jou rna l of F i n a nc i a l E c o n om i c s 7 ,
1 1 7 - 16 1 .
S pe n c e , M . , a n d R . Zec k h a u s e r , 1 9 7 1 ( May ) , I n c e n t i ve , i n forma t i o n a n d
i n d i v i d u a l a ct i on , Ame r i c a n Econom i c Re v i ew 6 1 ( 2 ) , 380- 387 .
Town s e n d , R . , 1 9 7 9 ( Oc t o be r ) , Opt i ma l contracts a n d c ompeti t i v e mar
kets w i t h c o s t l y s ta t e v e r i f i c a t i o n , J o u r n a l of Econom i c T h e o ry
2 1 , 265-293 .
86
Teece , D . J . , 1 98 1 ( Decembe r ) , I n te r n a l o rgan i z a t i o n a n d e c o n om i c per
fo rma n c e : An empi r i c a l ana l y s i s of t he p ro f i ta b i l i ty o f pr i nc i pa l
f i rms , T h e J o u rna l o f I n d u s t r i a l Econom i c s 30 ( 2 ) , 1 7 3 - 1 9 9 .
W i l l i amson , 0 . , 1 96 6 , The e c o n om i c s o f d i s c re t i o n a ry b e h a v i or : Ma n a
g e r i a l o bj ec t i ves i n the theory o f t he f i rm , P re n t i c e - Ha l l .
Wi l l i am s o n , 0 . , 1 9 7 3 ( May ) , Mar ke ts a n d h i e r a rc h i es : Some e l eme n t a ry
c o n s i dera t i o n s , Amer i ca n Ec onomi c Re v i ew 63 ( 2 ) , 3 1 6 - 3 2 5 .
W i l s o n , Robert , 1 97 5 ( S p r i n g ) , I n fo rma t i o na l e conom i c s of s c a l e , The
Be l l J o u r n a l of Economi c s 6 ( 7 ) , 184- 19 5 .
PART I I I
88
F I NANC I AL DE C I S I ONS , AGE N C Y CONS I D E RAT I ONS , AND
THE I NTE RNAL O RGAN I ZAT I O NAL STRUCTURE
I.
I NTRODUCT I ON
The re i s a con v i n c i ng body o f l i tera t u re wh i c h demo n s tra t e s
t h a t the modern c o rpora t i on i s c h a ra c te ri zed by a s e p a ra t i on of
own e rs h i p from c o n t ro l .
Sepa ra t i o n a l l ows q u a l i f i e d ma n a g e r s to
c o n t ro l the c ru c i a l re s o u rc e s o f the co rpo ra t i on presuma b l y at the
s h a re h o l d e r 1 S benefi ts .
Howe ve r , po s s i b l e c o n f l i c ts o f i n t e re s t
between s h a re h o l d e rs a n d ma n a g e r s g e n e ra te a s u bopt i ma l a l l ocat i o n
of re s o u rc e s wi th i n the organ i z a t i on wh i c h re s u l t i n a re d u c t i on
o f s h a re h o l de rs 1 wea l th .
The c o n t ra c t i ng e n v i ronme n t theo ry o f a g e n cy
1
h a s exami n e d
the s o u rc e s o f p ro d u c ti ve i neffi c i e n c i e s that re s u l t from t h e
man a g e r 1 S s e l f- i nterest b e h a v i o r .
A l l the re l ev a n t s tu d i e s i n t h i s
a rea have foc u s e d a t ten t i on on two i mportant e l eme n ts o f t h e ma n a ge r 1 S
contra c t i n g en v i ronme n t :
ma g n i t u d e o f a g e n cy c o s t s .
the ro l e o f c a p i ta l ma rkets a n d the
Howe v e r , the c u rre n t a g e n cy l i t e ra tu re
h a s exam i n e d the a g e n cy pro b l ems wi t h o u t ta k i n g i n to c o n s i dera t i o n
t h e i n tern a l orga n i z a t i on s t r u c t u re o f t h e modern c o rpo ra t i o n .
P re v i ou s research h a s a s s u me d t h a t a g e n cy c o s t s re s u l t ex c l u s i ve l y
from the a c t i o n s taken by the top ma n a g e r who i s ma k i ng de c i s i o n s
i n t h e a b s e n ce o f a ny i n tern a l re s t ri c t i ons o r con s t ra i n ts .
1
A s i mp l e taxonomy o f the rel e v a n t papers i n the a rea of
agency wa s presented i n the s e c o n d e s s ay . The re v i ew o f the ri s k
s ha r i n g a g e n cy l i terature wa s a l s o c o n d u cted i n Pa rt I I . O u r foc u s
- ------
89
E s s e n t i a l l y , t h i s a n a l y s i s has i s o l a ted the ma n a ge r i a l f u n c t i o n from
the i n tern a l corpora te s t r u c t u re .
I t h a s a l s o bee n a s s umed that
a l l po s s i b l e c o n f l i ct s of i n te re s t amo n g members of the o rg a n i z a t i o n
a re c o s t l e s s l y re s o l ve d .
The refo re , the a n a l y s i s o f a g e n cy pro b l ems
re a l l y dea l s wi t h one ty pe of fi rm :
the t ra d i t i o n a l , u ni tary firm
who s e top ma n a g e r a l l ocates h i s e ffort i n one produ c t i ve a c t i v i ty .
A l thou g h a g e n cy p ro b l ems a re i mp o rta n t i n a t ra d i t i o n a l f i rm ,
i s s ue s rel e v a n t to the n a t u re a n d a l l o ca t i o n o f the a g e n cy c o s t s
have not b e e n exami ned fo r a d i ffe re n t type o f f i rm , name l y , t h e
multidi visional firm .
C e rta i n l y , a mu l t i d i v i s i o n a l f i rm i s more
i mporta n t t h a n a t ra di t i o n a l f i rm both i n te rms o f the ma g n i tude
of the d i v e r s e re s o u rces that i t re g u l a te s a n d the n a t u re of i n tern a l
admi n i s t ra t i v e c o n t ro l o f v a ri o u s co rporate a s s e t s .
I n t e rn a l
confl i c t s o f i n tere s t i n a mu l t i d i v i s i o n a l f i rm h a v e a n i mpact on
the re s o u rce a l l o c a t i o n and f i n a n c i ng d e c i s i o n s .
C l e a r l y , the form
of i n te rn a l o rg a n i z a t i o n s t ructu re con s i dera b l y comp l i c a t e s the
a n a l y s i s o f a g e n cy c o s t s .
A s J e n s e n and Mec k l i n g ( 1 9 7 9 , p. 309 )
po i nted o u t ,
the a g e n cy pro b l em . . . ex i s t s i n a l l o rgan i z a t i o n s a t every
l e v e l of ma n a g ement i n a l l f i rms . . . . Unfo rtu n a te l y , the
a n a l y s i s of these more g e n e ra l org a n i z a t i o n a l i s s u e s i s
d i ffi c u l t beca u s e the n a tu re of t h e contractu a l o b l i g a t i ons
and r i g h t s a re much more v a r i e d . Neverthe l e s s , ( a g e n cy
c o s t s ) ex i s t a n d we bel i ev e t h a t extent i on s o f o u r a n a l y s i s
i n t h e s e d i re c t i o n s s h ow p rom i s e o f pro du c i ng h e l pfu l
i n s i g h t . . . 11
here , h owe v e r , i s to re v i ew the l i tera t u re rel e v a n t to t h e con
tract i n g e n v i ronme n t theory o f a g e n cy .
90
A.
Sco p e a n d P u rp o s e o f the An a l ys i s
I n th i s pa pe r , we propose to a u gmen t the re s ea rc h o n t h e
a gency theory by i n t rodu c i ng , a s a n a d d i t i on a l c o n s i d e ra t i o n , t h e
i n t e rn a l o rga n i z a t i o n a l s t ru c t u re .
The re s e a r c h reported i n t h i s
e s s ay h a s a c o n c e p tu a l o r i e n ta t i o n a n d p l aces emph a s i s on t h e
des c r i pt i v e a s pe c t s of f i n a n c i a l de c i s i on s ma de by ma n a g e rs w h o
func t i o n u n d e r t he i n fl u e n c e of a n i n tern a l admi n i s t ra t i v e s tru ctu re .
More s pe c i f i ca l l y , the paper dea l s w i t h i s s u e s o f a g e n cy c o s ts a n d
fi n a n c i a l de c i s i o n s a t t h e di vis ional le vel o f a we l l - d i v e rs i fi e d
corpora t i o n .
O u r purpose i s t h re e fo l d .
F i rs t , we exami n e i n a
ten ta t i ve way s ome c h a ra c te ri s t i c s o f the i n tern a l o rg a n i z a t i ona l
s t ru c tu re o f a we l l - d i v e rs i f i e d corpora t i on .
Sec o n d , we a t tempt
to d raw s ome po s s i b l e i mp l i c a t i o n s of the i n tern a l ma n a ge ri a l regu l a
t i o n fo r t h e i n v e s tme nt a n d f i n a n c i n g de c i s i o n s o f the f i rm .
T h i rd ,
we e x p l o re s ome of the mo s t l i ke l y e x p l a na t i o n s fo r t h e s u rv i v a l
o f the mu l t i d i v i s i on a l s t ructu re .
Ou r a n a l y s i s p l a c e s emp ha s i s o n s ome c o s ts a s s o c i a te d wi t h
t h e i n t e rn a l s t ru c t u re o f the f i rm , ra i s e s s ome q u e s t i o n s abou t t h e
rea l ma n a ge r i a l benefi t s o f d i v e rs i f i c a t i on , a n d e x p l ores the u s e fu l
n e s s of a n a g e n cy framewo r k a t a d i v i s i o n a l l e v e l o f a mu l t i d i v i s i o n a l
fi rm .
A n i mpo rta n t e l eme n t o f o u r a n a l y s i s i s t h a t we ta ke a
c ompa ra t i v e v i ewpo i n t , t h a t i s , we compa re the f i n a n c i a l de c i s i o n s
ma de by a d i v i s i o n a l ma n a g e r wi t h t h e a c t i o n s ta ken by a manage r
who ma k e s de c i s i on s u n d e r t h e s ame c i rcums t a n c e s b u t i n d e pe n de n t l y
o f a n i n terna l / h i e ra rch i a l s t ru c t u re .
91
The rema i nd e r of the p a p e r i s d i v i de d i n to fou r s e c t i o n s .
Sec t i o n I I re v i ews bri e f l y some theo r i e s dea l i ng w i t h t h e mu l t i
d i v i s i ona l s tru c t u re of a f i rm wh i c h i s c h a ra c te r i z e d by decentra l i
z a t i o n a n d p ro d u c t l i ne d i vers i f i ca t i o n .
The o b j e c t i v e h e re i s to
p ro v i de s ome reas o n s t h a t j us t i fy t h i s o rgan i za t i o n a l form , and
s u g g e s t t h a t d e ce n t ra l i z a t i on l e a d s to compet i t i ve a d a pt a b i l i ty .
Sect i o n I I I des c r i bes t h e a ge n cy costs from the po i n t o f v i ew o f
t h e c o n t rac t i n g e n v i ronmen t a g e n cy t h e o ry .
I n a dd i ti o n , t h i s
sec t i o n a ttempts to ana l yz e t h e i mporta n t e l eme n t s t h a t dete rmi ne
the a g e n cy costs i n a mu l t i d i v i s i on a l f i rm .
I n s e c t i o n I V we
compa re t h e f i nan c i a l d e c i s i o n s of a f i rm wh i ch operates w i t h one
i n dependent u n i t w i t h de c i s i o n s of a d i v i s i o n a l u n i t of a mu l t i
d i v i s i on a l f i rm ; we s ta te s ome p rop os i t i o n s rega rdi ng d i v i s i o n a l
man a g e r 1 S r i s k a t t i tudes , a n d we e x p l ore some t ra d e - o ffs t h a t
e x p l a i n t h e s u r v i va l o f t h e mu l t i d i v i s i on a l s tru c t u re .
Sec t i o n V
co n c l u d e s ou r d i s c u s s i o n w i t h the i n te rpre ta t i on o f o u r f i n d i n g s .
II.
T H E MULTI D I V I S I O NAL FORM O F O RGAN I ZAT I ON ,
THEOR I E S AND RE V I EW
A.
A Me t hodo l og i c a l Di s t i n ct i o n
A maj o r to p i c fo r re s e a rc h i n econom i c s a n d so c i a l s c i e n c e s
i s the s tu dy o f o r g a n i z a t i o n .
I n i t i a l l y the t h e o ry of t h e f i rm wa s
deve l o ped a s a fi r s t s te p towa rds t h e u n d e r s ta n d i n g o f maj o r
organ i z a t i o n a l compl ex i t i e s .
Re c en t l y , i n depe n d e n t re s e a rc h h a s
concen t ra t e d o n t h e i nt e r re l a t i o n s h i ps among the a c t o r s tha t i n t e ract
i n the f i rm ' s e n v i ro nme n t .
92
Coa�e ( 1 937 ) was the f i r s t t o a n a l y ze i s s u e s o f i n te r n a l
organ i za t i o n .
S i n c e h i s e x p l ora tory wo r k , a s e gme n t o f t he l i te ra
t u re re l e v a n t t o the theory o f t h e f i rm h a s dea l t w i t h i s s u e s of
th e a dmi n i s t ra t i v e s t ru c t u re o f t h e mod e rn c o rpora t i o n .
The re v i e w
of the l i t e ra tu re revea l s t h a t t h e re a re two d i s t i n c t me t h o d o l o g i e s
wh i ch a n a l yz e i s s u e s of i n t e r n a l o r g a n i za t i o n .
2
T h e f i r s t me thodo l ogy foc u s e s o n the p a r a l l e l exami n a t i on
of t h e i n ter n a l o r g a n i z a t i ona l s t ru c t u re a n d the c a p i ta l ma r ke t s .
Under t h i s a pp roac h , ma r ke t s a n d f i rms a re re ga rded a s a l terna t i ve
a dm i n i s t rat i ve s t ru c t u re s .
The trad i t i on a l produ c t i o n f u n c t i o n i s
mo d i f i ed i n order to i n c l u d e the concept of the f i rm a s a g overnance
s tr u c tu re .
Th i s p a ra l l e l t re a tme n t of markets a n d orga n i z a t i o n s
p ro v i des some d i rect ex p l a n a t i o n s o f t h e w i d e s p re a d mu l t i d i v i s i on a l
orga n i z a t i o n a l fo rm .
Acco r d i ng t o t h i s me t h o do l o gy , i nt e rn a l
org a n i z a t i o n a l s t ru c t u re s a re l i ke ma r k ets , s u b j e c t t o d i seq u i l i b r i um
and o t h e r forces t h a t a re s i m i l a r to t r a n s a c t i o n a l fri c t i o n s .
A l so ,
organ i za t i o n a l fa i l u res , l i ke ma rket fa i l u re s a re c ommo n .
T h e s e c o n d methodo l o gy i s o l a tes the f i rm from i t s extern a l
e n v i ro nme n t a n d a t tempts t o e x am i ne i s s u e s o f i n c e n t i ves , l a bor
re l a t i o n s , and produ c t i v i ty of the actors t h a t comp r i s e the fi rm .
The empha s i s i s p l a c ed o n the pa rts t h a t compri s e t h e f i rm ' s
2
T h i s c l a s s i f i ca t i o n i s ne i t h e r e x h a u s t i v e n o r r e f i ne d .
Ne vert he l es s , i t offers co n s i d e ra bl e e x p l a n a to ry powe r i n d e a l i ng
w i t h the ma i n top i c s d i s c u s s e d i n t h e l i tera tu re o f i n t e rn a l
a dmi n i s t rat i ve s t ructure .
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93
i nt e rn a l �pe ra t i n g u n i t s .
The i mpo rta n t o u tcome t h a t i s de r i ved
f rom t h e a p p l i ca t i o n of t h i s met h o d o l ogy i s a p a rt i a l ex p l a n a t i o n
o f h i e ra rc h i es adopted by o rg an i z a t i o n s .
Mo re s pe c i fi c a l l y , amo n g
t h e rea s o n s t h a t e x p l a i n the a d o pt i o n of h i e r a rc h i e s a re t he fo l
l owi n g .
( 1 ) F i rms a n d h i e ra r c h i e s a re needed to ex p l o i t t h e
a dv a n ta g e s o f team work ( Al c h i a n a n d Demsetz , 1 9 7 2 ) .
S i nce the
free - r i d e r prob l em i s a l way s p re s en t , teams req u i re c e n t ra l mon i to r s
to con tro l a n d d i s c i p l i ne poten t i a l s h i rkers .
Al t h o u g h cen tral
mon i to r s a re t h emse l ve s members o f teams a n d con s eq u e n t l y a re s u bj e c t
to t h e s ame dys fu n c t i o n a l be h a v i o r , a n a do p t i on o f a n i n s t i t u t i o n a l
s tr u c t u re w i l l e l i m i na te t h i s p ro b l em .
I n dee d , a c c o rd i ng t o Al c h i a n
a n d Deme s tz , t o p ma nagers a re mon i t o re d by potent i a l ta k e o v e r
ra i ders .
( 2 ) The n a t u re o f the emp l oyme nt re l a t i o n fo rces t h e f i rm
to adopt h i e ra rc h i e s ( S i mo n ( 1 9 5 7 ) , W i l l i am s o n ( 1 9 7 5 ) ) .
( 3 ) E c o n om i e s
o f s ca l e a s so c i a te d wi t h t h e produ c t i o n a n d tra n sm i s s i o n o f i n fo rma
t i o n i s a n ot h e r reason t h a t e x p l a i n s t h e i nt e rn a l o r ga n i z a t i o n a l
s tr u c t u re ( W i l so n , 1 9 7 5 ) .
I n the fo l l ow i n g s ec t i o n we a d d re s s t h e l i tera t u re t h a t
exami ne s the pa ra l l e l re l at i o n s h i p be tween ma r kets , o n o n e h a n d ,
a n d a dm i n i s t ra t i v e organ i za t i o n s , o n the o t h e r .
B.
Some I s s u e s o f I n te rna l O rga n i z a t i o n
Two maj o r c h a ra c te r i s t i c s a re a ttac hed t o t h e mode r n corpora
t i on .
F i rs t , the mo dern corpora t i o n c o n ta i ns ma ny d i s t i n c t opera t i n g
u n i t s who s e i n tern a l s t ru c tu re c ou l d a l l ow i t t o operate a s a n
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94
i n depe n d e n t bus i ne s s enterpri s e .
T h e second s a l i en t c h a ra c t e r i s t i c
i s t h a t i t emp l oy s a h i e ra r c hy o f m i d d l e - a n d top- s a l a r i e d ma n a g e r s
w h o s u pe rv i s e a n d c o o rd i n a te the wo r k o f the u n i t s .
The manage r i a l
h i e ra rc hy i s often comp l ete l y se pa ra te d from the owne r s h i p o f t h e
enterpri s e .
C h a n d l e r ( 1 9 7 7 , 1 982 ) exami ned t h e c h a n g i ng pro c e s s e s of
p ro du c t i o n and d i s t r i but i o n i n t he U . S . A . and t he way s t h ey have
been man a ge d .
He p rov i ded docume n ta t i o n of the e vo l u t i o n a ry p ro c e s s
of c o r p o r a t e s t ru c t u re a n d de s c r i bed t h e t ra n s fo rma t i o n o f t h e
corpora t i o n f rom i ts e a r l y u n i ta ry form ( U - Fo rm ) to i t s recent
mu l ti d i v i s i o na l s t ru c tu re ( M- Form ) .
I n h i s more r e c e n t wo r k ,
C h a n d l e r ( 1 982 ) a rg u e s t h a t t h e modern corp o ra t i on has r e p l a ce d t h e
ma r ke t me c h a n i sms wi th res p e c t to t h e coordi n a t i o n o f the e c o n omi c
a c t i v i ti e s a n d the p ro c e s s o f a l l o c a t i n g s c a rce r e s o r u c e s .
Al t h o u g h
t h e ma r k e t p l a c e reta i n s i t s func ti o n a s " th e g e n e ra t o r o f t h e
deman d fo r goods a n d servi ces , 11 i ts i n v i s i b l e ro l e o f a l l oc a t i ng
fund s a n d c o o rd i na t i ng cash f l ows w a s rep l a c e d by the " v i s i b l e
ma n ag e r i a l h a n d . 11
The ex p l a n a t i o n o f t h e ex i s tence o f t h e mu l t i d i v i s i o n a l fo rm
i s ba s e d on t h e a rgument o f i n te rna l i z i ng e x te rn a l i t i e s .
Possi b l e
exte rn a l i ti e s i n the f i rm ' s e n v i ronme n t i n c l ude t ra n s a c t i on c o s t s ,
i n fo rma t i on proce s s i n g c o s t s , a n d p ro d u c t ma rket u n certa i nt i es .
It
i s we l l known that a fun c t i ona l s tructu re e x p l o i ts s c a l e e c onomi e s ,
whereas a d i v i s i o n a l stru c t u re d u p l i ca te s f u n ct i o n s , u n l e s s the f i rm
i s l a rg e .
Howeve r , func t i o n a l depa r tments e n ta i l mo re e x t e r na l i t i e s
95
t h a n d i v i s i on s .
A l s o , mea s u r i n g t h e pe rforma nce of a fu n c t i ona l
depa rtme n t h a s no mea n i ng u n l e s s one knows the produ c t i o n func t i on .
C o n s e q u e n t l y , i t may be mo re d i ffi c u l t to s e t o p e ra t i ona l goa l s a n d
t o me a s u re pe rfo rma n ce f o r fu nc t i o n a l f i rms t h a n fo r mu l t i d i v i s i on a l
fi rms .
We offer t h ree rea s o n s t h a t e x p l a i n the ex i s te n c e o f the
d i v i s i o n a l form o f orga n i z a t i o n :
(a )
I n c ompl ete i n forma t i o n rega rdi ng the s ta te of the wo rl d .
One way t h a t l e a d s to the redu c t i on o f t h i s form of
i n fo rma t i o n a l a symme t ry i s by u s i n g the pr i ce system .
Howe v e r , there a re o p portu n i ty c o s t s of e x pa n d i ng t h e
nece s s a ry re s o u rc e s to become i n fo rme d .
In addi t i on ,
t h e re a re c o s t s o f n e g o t i a t i ng c o n t r a c t s o n c e pri c e s
a re kn own .
The e x i s te n c e of t h e s e i n fo rma t i on proce s s i ng
costs prov i des i n ce n t i v e s to expl o re dev i ce s for c i rcum
v en t i n g the ma r ke t .
Managers i n tern a l i z e t h i s form of
i n effi c i ency , a s l o n g a s the i n c reme n ta l i mp roveme n t
e x c e e d s t h e c o s t o f u s i n g t h e ma r ke t f o r t h i s p u r po s e .
(b)
Tra n s a c t i on c o s t s e c o n omi e s .
W i l l i ams o n ( 1 9 7 5 ) a r g u e s
t h a t tra n s a c t i o n s o u g h t t o be e x e c u te d a c ro s s ma rke t s .
Howev e r , the ma rket mec h a n i sm , due to t ra n s a c t i on c o s t s ,
c a n n o t regu l a te d i s c re t i o n a ry dec i s i o n ma k i n g .
Th u s ,
the re s po n s e to t h e rel a t i v e i n effi c i e n c i e s t h a t a p p e a r
i n t h e ma rket p l a c e i s t h e mu l t i d i v i s i on a l c o rpora t i o n .
T h i s mu l t i d i v i s i o n a l form b e h a v e s a s a s ma l l - s c a l e
96
c a p i ta l ma r k e t w i th more f u n c t i o n a l e f f i c i e n cy due t o
t h e i n terna l i z a t i o n o f t ra n sa c t i o n s .
T h e re fo re ,
fo r l a rg e f i rms d i v i s i on a l decentra l i z a t i o n f a v o r s
l e a s t - c o s t b e h a v i o r a n d s o a p prox i ma t e s p ro f i t max i mi z a
t i on better t h a n d o e s t h e fu n c t i o n a l form o f o rg a n i z a t i o n .
(c )
U n c e rta i n ty rega rd i ng t h e p rod u c t ma r k e t o r t h e
t e c h n o l ogy .
F i rms re s po n d i n a n a d a pt i v e man ne r to
s h i ft s i n ma rket d ema n d s by a ppropri ate l y mod i fy i ng
t he i r i n tern a l s t r u c t u re s .
D i v e rs i f i c a t i o n i n v a r i o u s
p ro d u c t l i ne s a n d v e rt i ca l o r h o r i zonta l i n teg ra t i on
a re examp l e s that p o i n t out the r e s u l ts o f s e l e c t i n g
a n i ntern a l s t ru c t u re t h a t s e rve s better ma r k e t n ee d s .
T h e refore , a d i vj s i on a l s t ructu re promotes a d a p t i ve ne s s
a t t h e d i v i s i o n a l a n d o rg a n i z a t i ona l l e v e l s .
The a bo v e d i s cu s s i o n s u g ge s t s t h a t t h e a do p t i o n o f a d i v i s i on a l
form by o r g a n i z a t i o n s i s a t ra d e - o f f propos i t i o n w h i c h i s b a s e d o n
a c o s t / b e ne f i t a n a l ys i s .
On t h e bene f i t s i de w e may i nc l u d e i n fo rma
ti o n a l effi c i en c i e s , d i v e rs i f i ca t i o n , s av i ng s o n c o o rd i n a t i o n c o s ts ,
a n d redu c t i o n s i n tra n s a c t i o n s c o s t s .
On the c o s t s i de we c o n s i der
po s s i b l e costs t h a t a r i s e from the d u p l i ca t i o n o f fu n ct i on s and
l os s e s i n e c o n om i e s o f s c a l e .
A l s o , t h e l i t e r a t u re o n h i e ra rc h i e s
h a s e s ta b l i s he d t h a t wi t h s ome 11dea dwe i g h t l os s e s 11 t h e re i s a top
c oo rd i n a t o r who res tri c t s the n umbe r o f o t h e r i n d i v i du a l s w i t h whom
anyone i n the o rg a n i z a t i o n s h ou l d ma i nta i n c o n ta c t .
3
3
Dea dwe i gh t
T h i s r e s t r i c t i o n i s c a l l ed s pa n o f c o n t r o l a n d t h e n umbe r
97
l o s s e s , i ri t h i s s e n s e , i n c l ude commu n i c a t i o n i ne ffi c i e n c i e s a n d
mon i to r i n g e rrors t h a t can b e s e e n a s " l o s s of c o n t r o l . "
The pre s s u re s of the c a p i t a l a n d the p ro d u c t ma rkets on
fi rms have a c c e l e rated t he d i ffu s i o n of the d i v i s i o n a l o rg a n i z a t i o n a l
fo rm .
I n fact , mu l t i d i v i s i ona l s t ru c t u re s have bee n doc ume n ted by
many re s e a r c he r s , a n d both the i n d u s t r i a l organ i z a t i on l i te ratu re
a n d the ma n a geme nt l i te ra t u re have ex ha u s t i v e l y ex ami n e d q u e s t i o n s
a d d re s s i n g t h e degree o f decentra l i z a t i on , s pa n o f c o n t ro l , a n d
othe r norma t i ve a n d beh a v i ora l fac tors affe c t i ng organ i z a t i o n a l
de s i g n .
I n recent s tu d i e s Armo u r a n d Teece ( 1 981 ) a n d Te ece ( 1 981 )
have docume n t e d a po s i t i ve c o rre l a t i on between profi ta b i l i ty a n d
t h e mu l t i d i v i s i o n a l organ i z a t i on s t ru c t u re .
I n t h i s s e c t i on we b r i e f l y re v i ew t he maj or wo r k s i n the a re a
of mu l t i d i v i s i on a l fi rm .
The modern c o rpora t i on i s c h a ra c t e r i z e d
by a h i e r a rc h i c a l s t ru c t u re i n wh i c h there i s a top coord i nator
whose ro l e i s to s u pe rv i s e the wo r k of d i v i s i on a l ma n a ge r s .
III.
AGENCY COSTS I N A M U L T I D I V I S I ONAL F I RM
The mu l t i d i v i s i on a l form re pre s e n ts a ra t i o n a l de compos i t i o n
of the f i rm • s affa i rs .
The re a re two u n i q u e fea t u re s a s s i g n e d to
the fu n c t i on of the top coord i n a to r of a di v i s i o n a l f i rm .
Fi rst ,
the top coord i nator ha s the re s p on s i b i l i ty to p l a n i n a s t rate g i c
man n e r t h e a l l oc a t i on of re s o u rc e s among the d i v i s i on s .
Secon d ,
of s t a g e s i n to wh i c h the contro l sy s tem i s s u bd i v i de d , i . e . , t h e
l e v e l s i n t h e h i e ra rc hy , i s t h e l en g t h of a c h a i n o f comma n d .
��
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98
t h i s c o o rd i n a t o r mon i to r s a n d c o n t ro l s the pe rfo rma n c e o f t h e
s emi a u to n omou s d i v i s i on s .
Ta k i ng i n to a c c o u n t t h e s e c o n s i derati o n s ,
an i mpo rta n t q ue s t i o n a ri s e s rega rd i n g the n a t u re o f t h e a g e n cy c o s t s .
I n a d d i t i on , a j u s t i fi a b l e c o n c e rn i s whether a g e n cy c o s t s a p p e a r
i n d i v i s i o n a l s t ru c t u re s i n a d e g ree t h a t c re a te p ro b l ems to the
overa l l effi c i e n cy o f the corpora t i o n .
J e n s e n a n d Mec k l i ng ( 1 9 7 6 ) a n a l yzed t h e a g e n cy c o s t s i n a n
owne r-ma n a g e r framewo r k .
The i r maj o r c o n c e rn was t h e exam i na t i o n
of the c o n t ra c t i ng e n v i ronme n t a n d t h e mon i to r i n g a n d b o n d i n g
a c t i v i t i e s o f the f i rm .
Age n cy c o s t s we re defi n e d a s the s um o f
the mon i to r i ng e x p e n d i t u re s p a i d by the p r i n c i pa l , the bo n d i ng
c o s t s pa i d by the a gent , and t he re s i d u a l l o s s e s .
Fama ( 1 980 )
i mp o s e d a n e x - po s t settl i n g u p me c h a n i sm t h a t d i s c i p l i n e s ma nage r i a l
beha v i o r , s o t h a t a gency c o s t s a re not a n i mport a n t con s i derat i on .
Howe v e r , the a s s umpt i o n o f a n e ffi c i en t l a bor ma rket ra i s e s ma ny
q u e s t i o n s regard i n g the re l e v a n c e of t h e a rgume n t .
N e v e rt h e l e s s ,
the J e n s e n a n d Mec k l i ng a n a l ys i s wa s c o n du c t e d a t t h e l e v e l of top
ma n a geme n t and wi t h the i n te n t i o n o f a d d re s s i n g i s s u e s o f owne r s h i p
a n d c o n t ro l .
I t was a s s ume d t h a t the top coord i n a t o r i s a n owner
ma n a g e r wi th f i x e d wage s , and o u t s i de s h a re h o l de r s were i n t ro d u c e d
i n t h e a n a l y s i s wi t hout a ny v o t i n g r i g h t s .
Al though Jensen and
Mec k l i ng a c know l edge t h e u s e fu l n e s s of a n e x te n s i on o f t he i r wo r k
a t d i ffe re n t o rgan i z a t i o n a l l e v e l s , the l i tera t u re l a c k s e v i de n c e
of s u c h a n exten s i o n .
From a d i fferent p e r s p e c t i ve , Fama a n d J e n s e n ( 1 983 ) a rg u e
t h a t de c i s i on s i n modern o rg a n i z a t i o n s can be decomp o s e d i n to
ope ra t i n g a n d s t rateg i c and that the f i rm 1 S dec i s i o n s po s s e s s
99
De c i s i o n
con s i s t s o f dec i s i o n ma n a geme n t a n d d ec i s i o n c o n t ro l .
ma n a g eme nt i n c l u d e s the i n i t i a t i o n o f propo s a l s and t h e i mp l eme n t a ti o n of rati fi e d dec i s i o n s , a n d de c i s i o n c o n t r o l i n v o l v e s t h e
mo n i to r i n g of pe rformance a n d the c h o i ce among the p ro po s a l s
pre s e n te d .
Fama a n d J e n s e n ( 1 983 ) s u g g e s t t h a t i f t h e re i s s e p a r a -
t i o n between de c i s i o n ma n a g eme n t a n d owner s h i p , the i n t e rn a l de c i s i o n
proce s s i s domi nated by an o rg a n i z a t i o n a l fo rm t h a t s e p a ra t e s de c i s i on
mana geme n t from de c i s i o n c o n t ro l .
The re s u l t o f t h i s i n tern a l
a r ran geme n t i s t h a t agency c o s t s a re i n s i gn i f i ca n t .
T h e d i ffu s e
n a t u re o f co rporate res i du a l c l a i ms a l l ows ma r ke t a n d o rg a n i z a t i o n a l
mec h a n i sms t o con tro l t h e a g e n cy p r o b l ems .
The s e mec h a n i sms i n c l u d e :
( a ) The s to c k ma r ke t , wh i c h i s a n extern a l mon i to r i n g dev i c e
s pe c i a l i z i n g i n p r i c i n g common s to c k .
Stoc k p r i c e s a re v i s i b l e
s i g n a l s t h a t s umma r i ze the q u a l i ty of i n te rn a l de c i s i o n s ; ( b ) The
ma rket fo r ta keovers , wh i c h can re p l a c e i neffi c i en t dec i s i o n con t ro l
mec h a n i sms , e i ther by a d i rect offer to purc h a s e s t o c k ( a tender
offe r ) , or by a n a ppea l fo r s h a re h o l de r votes fo r d i rectors (a proxy
f i g h t ) ; ( c ) The ex pe rt boards , wh i c h a re e s ta b l i s hed by the re s i du a l
c l a i ma n t s i n the proce s s o f de l e g a t i ng i n tern a l c o n t ro l to t he
agents .
The b o a r d s mon i to r the i n tern a l a g e n t ma r ke t .
The a bove -men ti o n e d rea s o n s h e l p to e x p l a i n t he redu c t i o n
o f a g e n cy c o s t s i n a l a rge co rporat i o n .
T o the e x t e n t t h a t there
i s a s e p a ra t i on o f d e c i s i o n ma na geme n t from de c i s i o n con t ro l i n a
mu l t i d i v i s i o na l f i rm , a g e n cy c o s t s a re not a n i mportant c on s i dera t i o n .
4
T h i s i s a n i nd i re c t i mp l i c a t i on of the Fama a n d J e n s e n ( 1 983 )
framewo r k .
4
100
Desp i te t h e re l ev a n c e of t h i s a rg u men t , more research i s needed to
e s ta b l i s h t h a t a g e n cy costs a re a b s e n t i n a mu l t i d i v i s i ona l fi rm ,
wh i ch i s c h a ra c t e r i z ed by a d i ffu se own e rs h i p s t ru c t u re a n d a wea k
form of s e p a ra t i o n between de c i s i on ma n a geme n t a n d dec i s i o n c o n t ro l .
On l y a d i ffu se de c i s i on c o n t r o l sys tem can l i mi t the powe r of
i n d i v i du a l de c i s i o n agents to expropri ate the i n te re sts o f res i d u a l
c l a i ma n t s .
I t i s su gges ted t h a t a d i ffused de c i s i o n sys tem l ea d s
to d i s a g g re g a t i on o f s pe c i fi c i n fo rma t i on among many i n te rna l a g e n t s .
T h i s i s the re su l t o f both the de l e ga t i o n o f de c i s i o n s to d i ffe re n t
a g e n t s a n d the s e p a ra t i on o f de c i s i o n ma na geme nt a n d c o n t ro l a t
v a r i o u s l ev e l s of t h e organ i z at i o n .
Agency c o s t s c a n be reduced
by a s s i g n i n g the i n i t i a t i o n and i mp l eme n ta t i on of de c i s i o n s to t h o s e
a g e n t s w i t h v a l u a b l e s pe c i a l i z e d know l edge .
I n a d i v i s i on a l organ i z a t i o n t h e re a re two con d i t i o n s t h a t
h a v e perva s i ve con sequences fo r t h e f i rm ' s i n te rna l e ff i c i ency :
bou n ded rat i on a l i ty , and se l f- i n t e re s t behav i o r f rom the pa rt of
v i rtu a l l y a l l pa rti c i pa n t s o f the o r g a n i z a t i o n .
S i mon ( 1 957 ) a n d
Wi l l i amson ( 1 9 7 5 ) ana l yz ed t h e se c o n d i t i on s a n d ex p l a i n e d t he
na t u re o f c o n f l i c ts tha t a r i s e when man a ge r i a l re s p o n s i b i l i ty i s
a s s i g n e d to huma n actors .
W h i l e i t i s u sefu l to d i s t i n g u i s h b o u n d e d
ra t i o n a l i ty a n d s e l f - i n te r e s t be h a v i o r , Fama a n d J e n s e n co l l a p s e
these two terms u n d e r t h e h ea d i ng o f " a gency c o s t s . 11
Howe ve r ,
the d e c ompo s i t i on o f a g e n cy c o s t s can be h e l pfu l i n exami n i n g t h e
i nte rtempo ra l contract i ng p ro b l em i n a d i v i s i o na l f i rm .
101
IV.
A.
A COMPA R I SON
A Di v i s i o n a l U n i t v s . An I n de pe n d e n t U n i t
We c o n s i d e r a mu l t i d i v i s i o n a l f i rm w h i c h ope ra te s wi t h
n - d i v i s i on s .
E a c h d i v i s i on ope ra t e s i n depende n t l y from a l l the
others i n d i ffe re n t produ ct l i ne ( s ) .
We a l s o a s s ume that e a c h
d i v i s i o n ha s a c h i e v e d e c o n om i e s o f s c a l e i n i t s f u n c t i o n a l a re a a n d
t h a t i t i s fu l l y c ompet i t i v e wi t h o t h e r u n i ts o f s i mi l a r p ro d u c t
l i ne ( s ) i n the ma rket .
I n ot h e r word s , di v i s i on a l u n i t s
( h e re a fter
D . U . ) a re fu l l y c ompa t i b l e wi t h compet i n g i n dependent u n i t s
( I.U. ) .
The o n l y d i ffe rence i s the n a t u re a n d degree o f fo rces t h a t re s t ri ct
ma n a ge r i a l be h a v i o r .
Speci f i c a l l y , the man a g e r o f a D . U . ha s to
recon c i l e the dema n d s o f t h e fo l l ow i n g c o n s t i tue n c i e s :
(a)
Ca p i ta l ma rkets c o n s t i t u e n cy :
L e n d e r s o f c a p i ta l wa n t
to h a v e g reater a s s u r a n c e t h a t t h e i r we a l t h wi l l b e
re t u rn e d i n tact .
S ha re ho l de r s ' we a l t h i s d i re c t l y
e n h a n c e d or d i mi n i s he d by a c t u a l t ra n s fe r s o f f u n d s
u n d e r ma na gement c o n t r o l .
Ca pi ta l ma rkets c on t i n u o u s l y
e v a l u a t e ma n ag e ri a l performa nce a n d a c c o rd i n g l y rewa rd
or pena l i ze dy s fu n c t i o n a l beh a v i o r by p ro v i d i n g or
r e s t r i c t i ng s o u rc e s o f c a p i ta l for futu re e x p a n s i o n .
(b)
Product ma rket c o n s t i t u e n cy :
C u s tome rs dema n d rel i a b l e
p ro d u c t s at the l owe s t pri c e , a n d s u p p l i e rs o f factors
o f produ c t i o n a re i n tere s te d i n f i n d i n g c u s tome rs w i l l i n g
to pay the h i g h e s t s u s ta i n a b l e pri c e s .
a c ompet i t i v e p ro d u c t i s o bv i ou s .
The dema n d fo r
.
--------- -------------
1 02
(c)
I n t e r n a l organ i za t i o n con s t i tuency :
De c i s i o n s made by
a D . U . ma nager s ho u l d be i n l i ne wi t h the i n t e r n a l
req u i reme n t s , t h a t i s , ru l e s that h a v e been e s ta b l i s h e d
by the t o p man a g e r s .
I n parti cu l a r , the ru l e s may
re q u i re , amo ng o t h e r t h i n g s , the i n teg ra t i on of bu s i ne s s
u n i ts a n d t h e ba l a nc i ng o f the p ro d u c t portfo l i o .
The
fo rme r i mpl i e s a l l oc a t i o n o f fu n d s i n o r d e r to a c h i eve
g rowt h a n d ma r k e t s h a re .
The l a t t e r i n d i cates pote n t i a l
c ro s s - f i nanc i n g o r c ro s s - s u bs i d i z a t i on i n o rde r to
i mp l eme n t the de s i ra b l e d i v e rs i f i ca t i o n o b j e c t i ve s .
A f i rm w i t h a n I . U . wi l l h a v e to recon c i l e the dema n d s o f
t h e prod u c t ma r ke t a n d c ap i t a l ma rket c o n s t i tuenc i e s .
Mana gers o f
an I . U . a re eva l u a t e d by t h e p ro d u c t ma r kets i n the s ame way a s a re
D . U . f i rms .
I n fa ct , t h e p ro d u c t ma rket con s t i tue ncy wi l l be be s t
s a t i s f i e d when the corporati o n ' s p ro fi t ma rg i n prov i des t h e l owe s t
a ccept a b l e r e t u r n t o i n v e s to r s .
Howe ve r , a D . U . f i rm d i ffe rs from
an I . U . f i rm w i t h respect to i nt e rn a l s t r u c t u re a n d a dm i n i s t ra t i ve
regu l a t i o n s .
The ma nager of a D . U . fi rm i s eva l u a t e d not o n ly o n
the b a s i s of ma rket s i g n a l s i n d i c a t i ng t h e compe t i t i vene s s of t h e
produ c t , but a l so acc ord i n g to the e x t e n t o f h i s c o n formi ty t o a n d
comp l i an c e w i t h i n te rna l ru l e s .
A l l ot he r t h i ngs be i n g e q u a l , ma n a g e rs o f I . U . a n d D . U . f i rms
face the same opportu n i ty se t .
Howeve r , t h e e x i stence o f the
i n t e rn a l o r g a n i za t i o n a l c o n s t i t u e n cy a f fe c t s a bu s i n e s s u n i t ' s
de c i s i on s a n d a l t e r s ma n a g e r i a l dec i s i o n ma k i ng a t the d i v i s i ona l
1 03
l ev e l i n two res pec t s .
F i rs t , t h e i n trodu c t i o n of a h i e r a rc h i ca l
ma n a ge r i a l s t ru ctu re d ra s t i c a l l y mo d i f i es t h e o p p o rtu n i ty s e t fac i n g
the D . U . ma n a ge r .
Seco n d ly , t h e e v a l ua t i o n c r i te r i a a p p l i ed a n d
t he max i m i z a t i on dec i s i o n proc e s s emp l oye d by t h e D . U . ma n a g e r a re
g e n e ra l l y d i ffe rent from t h o s e u s e d by a n I . U . ma n a ge r .
For t h e s e
rea s o n s w e wou l d e x pect t h a t fi n a n c i a l dec i s i o n s m a d e by a D . U .
man a g e r wou l d be d i fferent from t h o s e made by a n I . U . ma n a g e r .
Both
the i n t e rn a l ma n a ge r i a l e n v i ronme n t and the c a p i ta l ma r k e t s re s t r i c t
the p o s s i b l e ra nge of a c t i o n s t h a t c a n be ta ken by a D . U . ma nag e r .
Thu s , we c a n s ta t e t h e fo l l owi n g propo s i t i o n s :
P ro p o s i t i o n I
A D . U . ma n a g e r h a s the tendency to a d o p t f i n a n c i a l p o l i c i es
wi th s h orter h o r i z o n s .
Di scu s s i on
The p e rforma n c e o f a D . U . ma n a g e r i s ba s e d o n a c o n t r o l sys tem
wh i c h i s fi n a n c i a l i n n a t u re .
rat i o na l i ty 11
5
The top coord i n a t o r , h a v i n g 11 b o u n d e d
a n d i n comp l e te i n fo rma t i o n concern i n g t h e o p e ra t i n g
p ro b l ems o f t h e bu s i ne s s u n i t s , w i l l s e e k t o a d o p t c o n t r o l sys tems
wh i c h a re s ta n d a rd i z ed a c r o s s d i v i s i o n s .
By a c c e p t i n g s ta n d a rd i z e d
contro l p ro c e d u re s , t o top coord i na t o r o f a mu l t i d i v i s i o n a l corpora
t i o n can extract t h a t port i on o f i n fo rma t i on h e needs i n o rd e r to
re v i ew d i v i s i o n a l performa n c e .
5
B o u n d e d ra t i ona l i ty refers to h uman beh a v i o r t h a t i s
11 i nte n d e d l y ra t i on a l but on l y l i m i ted s o 11 ( S i mo n , 1 9 5 7 ) . I n d i v i d u a l s
expe r i e n c e p hy s i c a l l i m i t s w i t h re s pe c t to t he i r a b i l i ty to s t o re ,
rece i ve a n d p ro c e s s i n fo rmat i o n . Under c e rta i n ty , c on t i n g e n t c l a i m
1 04
A D . U . ma n a g e r w i l l h a v e more i nforma t i o n t h a n t h e t o p
c o o rd i n a t o r a b o u t t h e opport u n i ty s e t , e x pe c t ed re tu rn s , a n d o t h e r
v a r i a b l e s wh i c h a re c ru c i a l to t h e f i n an c i a l dec i s i o n s fo r t h e
d i v i sion .
Al t h o u g h he knows the t r u e proba b i l i ty d i s t r i bu t i o n o f
a p roj e c t 1 S c a s h f l ow , i t i s d i ffi c u l t t o c ommu n i cate t h i s i nfo rma t i o n
to t h e top coord i n a t o r w i t h c re d i b i l i ty .
P ro b l ems a s s o c i a ted w i th
i n format i o n a l i mpactednes s ( W i l l i amson ( 1 97 5 ) ) further c omp l i cate
the t ra n sm i s s i on o f i nforma t i on .
6
In a d d i t i on , t h e D . U . man a g e r
knows t h a t he i s be i ng j u dged o n t h e ba s i s o f u n i form s t a n da r d s t h a t
do n o t a l l ow for e x p l anat i on s o f u n expec ted , be l ow t h e a ve rage ,
perfo rma nce .
I n v i ew of the a b o v e st ated c o n d i t i o n s , t h e D . U .
ma n a g e r h a s t he tendency to take s h o r t - te rm ac t i on s .
Fi nan c i a l p l a n s
t h a t gene r a te l o n g - term re s u l ts i n v o l v e p re s e n t s a c r i f i c e s f o r fu t u re
benefi t s .
S i nce t he D . U . man a g e r i s j udged on t h e ba s i s o f s t a n d
a rd i z ed f i n a n c i a l c r i te r i a , the a d o pt i on of l on g - t e rm p l a n s w i l l
req u i re e x p l a n a t i o n s re g a rd i n g d i m i n i s h i ng c urrent r e t u r n s .
E x p l a n a t i o n s of t h i s s o rt a re d i ffi c u l t to be p r e s e n t e d to the t o p
c o o rd i n a t o r i n a c re d i b l e way .
I t s h ou l d be note d t h a t th i s i s not
c on trac t s c a n e l i mi n ate t h i s pro b l em . I n a n u n certa i n e n v i ro nme n t
bounded ra t i o na l i ty comp l i ca t e s econom i c pro b l ems .
6
I n fo rma t i o n i mpactedne s s i s re l e vant to a symme t r i c i n fo rma
t i on amo n g a g e n t s . I t ex i s t s when the t r ue u n d e r l y i n g c i rcums t a n c e s
re l e vant to a dec i s i on a re k n own to one party bu t c a n not be c o s t
l e s s l y c ommun i c a ted to o t he r p a r t i e s . W i l l i amson ( 1 9 7 5 ) d i s t i n g u i s he d
i n forma t i o n i mpactedne s s between buye r s a n d s e l l e rs a n d s pec i f i e s
c o n d i t i o n s for e x - pos t a n d e x - a n te i n fo rma t i on i mpac tedne s s .
105
a fa i l i n g of the top c o o rd i n a to r , but s i mp l y a re f l e c t i on of the
fa ct t h a t he e x pe r i ences l i mi ta t i o n s w i t h re s pe c t to t h e proce s s i n g
o f d i verse a n d comp l e x i n fo rma t i o n he i s con fron ted w i th .
To a v o i d
t he p ro b l em o f i mpe rfec t commun i ca t i on w i th the top c o o rd i n a tor ,
the D . U . ma n a g e r p re fers to ta ke a c t i o n s ha v i n g s h o rt -term re s u l ts
that w i l l gene rate both good news i n the ca p i ta l and p ro d u c t ma r k e t
c on s t i t u en c i e s a n d a t the same t i me s a t i s fy the i n ter n a l ma n a g e r i a l
ru l es .
P ro po s i t i o n · ! !
The D . U . ma n a ge r t e n d s t o be r i s k-ave rse .
A l l o t h e r t h i ngs
be i n g e q u a l , he w i l l prefer to acce pt proj e c t s that a re l e s s r i s ky
t h a n others .
D i scu s s i on
I t i s po s s i b l e fo r a r i s ky p roj e c t to g e n e r a te n e g a t i v e
retur n s .
I t i s v e ry h a rd for the D . U . man a g e r to c ommu n i c a te i n
a c red i b 1 e a n d v e r i f i a b 1 e way the " c o r re c t 11 e x - a n te pro b a b i l i ty
d i s t r i bu t i o n o f a r i s ky i n v e s tme n t .
On the e x - p o s t ba s i s t h e top
coord i na t o r mi g h t i n te rpret neg at i ve re s u l ts as a n i n d i c a t o r of
ma n a g e r i a l i n a b i l i ty or a s a l a c k of e ffort i n i mp l eme n t i ng pro f i t
a b l e proj e c t s .
Moreove r , the ca p i ta l ma r kets w i l l rea ct u n fa v o ra b l y
t o t h e a n n o u nceme n t o f a fa i l u re .
On the othe r han d , on a n e x - p o s t
ba s i s , pos i t i ve performa n c e w i l l b e j u s t i f i ed on the bas i s of
fa vora b l e ma r ket c o n d i t i on s or p u re l u c k ra t h e r than o n the D . U .
ma n a g e r ' s a b i l i ty to ta ke c o rre c t a c t i on .
A more p l a u s i b l e
106
e xp l a n a t i on wo u l d be that pre v a i l i n g i n fo rma t i o n a symme t ry makes
i t d i ffi c u l t for the top coord i n a t o r to d i s t i n gu i s h rea l manager i a l
e ffort from s ta te u n certa i n ty .
U n d e r t h e s e c i rcums t a n ce s , the
D . U . ma n a ge r perc e i v e s a pote n t i a l i mb a l a n c e i n the e v a l u a t i on o f
h i s pe rfo rma n c e by s u pe r i ors a n d o t h e r c o n s t i t u e n c i e s :
h e fee l s
that he i s c h a rged w i th t h e fu l l b l ame for a ny fa i l u re , a n d rece i ve s
o n l y part i a l c re d i t for a ny s u pe r i o r pe rforma n ce .
T h e refore , g i ve n
the D . U . manager 1 S i n a b i l i ty t o a c c u ra te l y c ommu n i c a t e the r i s k
rewa rd tradeoffs of a f i n a n c i a l p l a n a n d h i s percept i o n o f be i n g
j u dged u n fa v o ra b l y by a c c e pt i ng r i s ky p roj e c t s , he w i l l be forced
to adopt po l i c i e s that ex h i b i t r i s k - a ve r s i o n .
I n e x t reme c a s es , t h e a bove propos i t i o n s u g g e s t s t h e fo l l owi ng
con c l u s i on :
we l l - d i vers i f i e d f i rms o f the type that we have
des c r i bed , des p i te t h e i r a b i l i ty to bea r bu s i ne s s r i s k s , behave
a s r i s k - a ve r s e i n s t i tu t i o n s .
Therefore , the bene f i ts from d i vers i
f i c a t i o n c ome from a c o s t/ be n ef i t a n a l ys i s .
The c o s t i nc l u d e s
l o s s e s d u e t o a n unwi l l i n g n e s s t o adopt r i s ky po l i c i e s .
P ro p o s i t i o n I I c o n t ra d i c t s J e n s e n a n d Mec k l i n g 1 s resu l t s .
Al so ,
A l thou g h
i n a d i ffere n t s e tt i n g , J e n s e n a n d Me c k l i ng ( 1 9 7 6 ) c l a i m t h a t
t he own e r-ma n a ge r , i n a n a ttempt t o ex p l o i t o u t s i ders 1 wea l t h ,
wi l l adopt r i s ky proj ec t s .
Howe v e r , i n tern a l ma n a ge r i a l reg u l a
t i o n , a s wa s d i s c u s s e d a bove , w i l l prevent t h i s po s s i b i l i ty .
T h e prev i ou s a na l ys i s i n d i c a t e s that t h e admi n i s t r a t i v e
s tru c t u re o f a mu l t i d i v i s i o n a l f i rm g e n e rates s u b s ta n t i a l o rgan i za
t i on a l c o s t s .
W e n ame t h e s e c o s t s ma nage r i a l regu l a tory c o s ts to
107
d i s t i n g u i s h them f rom t he a g e n cy c o s t s o f t he Jensen and Me c k l i ng
type .
Ma nag e r i a l regu l a to ry c o s t s refe r to t he a g g re g a t i on o f d i v i
s i o n a l l o s s e s due to i n te rna l a dmi n i s t ra t i ve regu l a t i o n .
These
costs a re t h e resu l t of the beh a v i o r of d i v i s i o na l ma n a g e r s who
re spond to ma rket and o rg a n i z a t i o n a l fo rces .
I n t h i s s e n s e , dead
we i g h t l o s s e s occur ma i n l y because o f the i n d i re c t c o n s t ra i n t s p l a c e d
on d i v i s i on a l ma n a g e r s by t h e i n te rn a l o rgan i z a t i o n a l s t ru c tu re .
On t h e o t h e r ha n d , a g e n cy c o s t s repre s e n t l o s se s wh i c h r e s u l t from
t h e se l f- i n t e re s t beh a v i o r of ma n a g e rs who pu r s u e per s o n a l g oa l s
wh i c h a re genera l l y d i ffere n t f rom o rgan i za t i o n a l g oa l s .
Mo n i t o r i n g ,
bond i n g , a n d re s i d u a l l o s s e s re f l ect s u bopt i ma l ma n ag e r i a l dec i s i o n s
at t h e top o f the o rg an i z a t i on .
M a n a ge r i a l regu l a to ry c o s t s a re
the ma n i fe s t a t i o n o f the i mperfe c t i o n s of the h i e r a r c h i c a l s tru ctu re
of t h e mod e rn cor po ra t i o n .
B.
Expl o r i ng Some Trade-offs
Lo o k i n g at t he c o n s e q u e n c e s o f the ma nage ri a l / i n t e r n a l regu l a
t i o n , we c a n c o n c l u de t h a t t h e re a re s ome p l a u s i b l e c o n d i t i o n s wh i ch
force the f i rm to opera t e w i t h i n te rna l costs .
Whi l e th i s i s not
nece s s a r i l y t ru e fo r a l l compa n i e s , some n e g a t i v e forc e s a re e v i d e n t l y
p re s e n t a n d mi g ht p revent the f i rm f rom a c h i e v i n g the fu l l bene f i t s
from d i v e r s i fi c a t i on .
Howe v e r , a bu n d a n t e v i dence i nd i c a te s t h a t
t he mu l t i d i v i s i o n a l s t r u c t u re i s a c ommon o rg a n i za t i o n a l form .
In
o rd e r to ex p l a i n t h i s regu l a r i ty , we s h ou l d c on s i d e r n o t o n l y the
i n tern a l ma n a g e r i a l c o s t s , but a l so the benefi t s from opera t i n g
syn e rg i e s a n d d i v e rs i fi c a t i o n .
1 08
I n s e c t i o n I I ( b ) o f th i s e s s ay we pre s e n te d s ome e c o n omi c
rea s o n s t h a t j u s t i fy the ex i s t e n c e o f the mu l t i d i v i s i o n a l f i rm .
Here ,
we prov i de a d i ffe re nt rea s o n wh i c h i s ba sed o n ma n a g e r i a l synerg i e s .
J e n s e n a n d Ru b a c k ( 1 983 ) a n d J e n s e n ( 1 983 ) a rg u e t h a t ma n a g e r s a re
s e l f i n tere s te d i n d i v i du a l s , bu t t h e e n v i ronme n t g i v e s them re l a t i v e l y
l i t t l e free dom t o s a t i s fy the i r i n tere s t s .
Amo n g o t he r t h i n g s , t h e
ma rket for c o rporate contro l fo rces t h e t o p ma n a g e r t o b e q u i te
effi c i e n t i n ma n a g i ng co rporate re s o u rc e s .
Ce rta i n l y , t h e re i s
i n fo rma t i o n a l a symme try between t h e top ma n a g e r a n d D . U . ma n a g e r s
reg a r d i ng the g e n e ra l a dm i n i s t ra t i o n o f the corpora te a s se t s .
The
behav i o r o f the D . U . ma n a g e r towa rds ri s k i s a re f l e c t i o n o f the
fact that the top ma n a ge r does not wa n t to fo l l ow po l i ci e s that w i l l
j eo p a rd i z e h i s a b i l i ty to compete e ffe c t i v e l y for the r i g h t to
ma n a g e the f i rm • s c o rporate re s o u rc e s .
A s i t wa s s tated a bove , t h e re i s a c o s t s i de a n d a benef i t
s i de o f t h e a n a l y s i s of the d i v i s i o n a l f i n a n c i a l de c i s i o n s .
A
mu l t i d i v i s i o n a l o rg a n i z a t i on repre s en t s a b a l a n c e between t h e
marg i n a l bene f i t s a n d the ma rg i na l c o s t s a s s o c i a te d w i t h a dd i t i ona l
d i v i s i onal i zati on .
The c o s t s i de i n c l u d e s the ma n a g e r i a l regu l a t o ry
c o s t s wh i c h a re the re s u l t o f t h e s u b s t i tu t i o n o f the ma rket
d i s c i p l i na ry fo rces wi t h a n i mperfect a dmi n i s t ra t i v e s t ru c t u re .
On
t he b e n e f i t s i de we con s i de r the a rgume n ts p re s e n te d i n s e c t i o n I I ( b ) .
Obv i o u s l y , a mu l t i d i v i s i o n a l orga n i z a t i o n h a s s u rv i v a l v a l u e o n l y
when ma rg i n a l be n e f i ts exceed ma rg i n a l c o s t s .
1 09
To s ay t h a t a mu l t i d i v i s i on a l f i rm h a s s u rv i v a l v a l ue does
not i mp l y t h a t a f ree - s ta n d i n g f i rm , an I . U . f i rm , wi l l d i s a p pe a r
from the ma r ke t .
That i s , the fa c t t h a t a d i v i s i on a l u n i t o f a
mu l t i d i v i s i o n a l f i rm overcome s co s t l y c o n s t ra i n t s doe s n o t nece s s a r i l y me an t h a t o t h e r f i rms w i t h d i ffe re n t i nte rn a l s t ru c t u res w i l l
fa i l to e x i s t .
The rea s o n for t h i s i s that I . U . f i rms a n d D . U . f i rms
repre s e n t a l terna t i v e s , w h i l e not n e c e s s a r i l y c ompa t i b l e , ways o f
o rg an i z i n g economi c a c t i v i ty .
T h ey d i ffe r o n l y i n the me t h o d they
u s e to c o n s t ra i n behav i o r a n d , t h e refore , e x pe r i e n c e d i f f e re n t l ev e l s
of c o s t s for t h e s ame t ra n s ac t i o n s .
T h e admi n i s t ra t i ve s t ru ctu re
of a mu l t i d i v i s i on a l fi rm mod i f i e s the opportun i ty set faced by D . U .
ma n ag e rs by re p l a c i ng a s e r i e s o f f i n a n c i a l dec i s i o n s w i t h a s i ng l e
emp l oyme n t con tra ct .
Th i s emp l oyme n t contract pro d u c e s beh a v i o ra l
con s t ra i n t s w h i c h fo rce D . U . ma n a g e r s to ma ke c o s t l y s u bop t i ma l
dec i s i on s .
Al t h o u g h ca p i t a l ma r kets pena l i z e s u bopt i ma l ma nage ri a l
dec i s i o n s , i t i s ex pected t h a t t h e i r c o r rect i ve fo rce w i l l t a k e i n to
account t he bene f i ts a s s o c i a t e d w i t h the i n terna l o rg a n i z a t i o n a l
s t ru c tu re .
7
V.
CONCL US I ONS
The foc u s of th i s e s s ay has been on the fu r t h e r de v e l opme n t
7
c a p i ta l ma r kets a re ra t i ona l i n a s s e s s i n g manage r i a l d e c i s i o n s .
When c ap i ta l ma rkets d i s c i p l i ne the D . U . ma n a g e r o r the t o p coord i n a t o r
of a M D f i rm , t h ey ta ke i n t o con s i d e ra t i on t h e pro b l ems a s s o c i a ted
w i t h the i n te rna l o rgan i z a t i o n a l s t ru c t u re .
1 10
of the a g e n cy theory .
We be l i e ve t h a t the i n te g ra t i o n o f the a g e n cy
l i te ra t u re wi t h the concepts o f i n t e rna l organ i z a t i o n w i l l p rov i de
an opera t i ona l framewo r k wi t h i n w h i c h o b s e rva b l e ma n a ge r i a l beh a v i o r
can be e x p l a i n e d u n d e r a s e t o f re a l i s t i c a s s umpt i o n s .
I n t h i s paper we a d d re s s t he q u e s t i on :
How a re t h e f i n a n c i ng
dec i s i o n s of a ma n a g e r who i s re s po n s i b l e for the pe rforma n c e o f
a d i v i s i o n a l f i rm d i ffe re n t from s i m i l a r d e c i s i on s t h a t wo u l d be
made by the s ame ma n a g e r i f he were ma n a g i n g a n a u t o n omo u s u n i t
( o u t s i de the i n f l uence o f the mu l t i d i v i s i o na l f i rm ) ?
We ex ami n e d
th i s q u e s t i o n i n s e c t i o n I V o f t h i s pape r , u s i ng a c o n c e p t u a l
framewo r k .
The c e n t r a l hy po t he s i s o f o u r a n a l ys i s c o n c e r n s the natu re
of fi n a n c i a l de c i s i o n s ma de by d i v i s i on a l ma n a g e r s .
I t was s u g ge s te d
t h a t D . U . ma n a g e r s t e n d t o s e l e c t fi n a n c i a l p o l i c i e s wi t h s hort-term
hori z o n s .
I n a d d i t i o n , we p ro v i de a rgume n t s t h a t s u p po rt the
hy pothe s i s that D . U . ma n a g e r s prefe r to accept l e s s r i s ky p roj e c t s .
The maj o r c a u s e o f t h i s beha v i o r wa s e x p l a i ne d o n the ba s i s of the
i n tern a l re g u l a to ry e n v i ronme n t t h a t a ppears i n mu l t i d i v i s i o n a l
fi rms .
I n o u r framework we i de n t i f i e d s ome dea dwe i g h t l o s s e s
( ma n a g e r i a l re g u l a to ry c o s t s ) wh i c h a re the re f l e c t i o n o f t h e fa c t
t h a t a d i v i s i o n a l ma n a g e r o pe ra t e s u n d e r d u a l c o n s t ra i n t s :
the
i n tern a l a dmi n i s t ra t i ve s t ru c t u re , a n d the ma rket d i s c i p l i na ry
force s .
I t wa s a dvocated t h a t , des p i te the c o s t s t h a t resu l t from
t he i n tern a l o r ga n i z a t i o n a l s t ru c t u re , the mu l t i d i v i s i on a l orga n i z a
t i o na l form h a s a s u rv i v a l v a l u e s i n c e t h e ma rg i n a l bene f i t s exceed
the ma rg i n a l c o s ts .
111
Ou r wo r k dea l s wi t h i s su e s t h a t l i n k the i n terna l o r ga n i z a
t i o n wi t h t h e p r i n c i pal -agent mode l .
S t i l l a n u n se t t l ed i s s u e i s
t h e perva s i vene s s o f the J e n s e n a n d Me c k l i ng ty pe a gency c o s t s i n
m u l t i d i v i s i ona l s t r u c t u re s .
Even i f we accept the t h e s i s devel oped
by Fama a n d J e n s e n ( 1983 ) rega rd i n g t h e a ge n cy costs i n a mu l t i
d i v i s i o n a l form , t h i s e s say h a s s h own t h a t t h e re a re some o t h e r
poten t i a l c o s t s t h a t prevent the f i rm f rom o pe rat i ng w i t ho u t any
i nterna l f r i c t i o n .
I t i s ou r be l i e f that t he man a ge r i a l re g u l ato ry
c o s t s c a n prov i de a r i c h e n v i ronme n t w i t h i n wh i ch the i n v e s tme n t
a n d f i n a nc i ng dec i s i ons c a n be exam i n e d i n a p ra c t i c a l ma n n e r .
I n de e d , the p ro pos i t i on s dev e l oped i n t h i s e s s ay h a ve s ome pract i ca l
i mp l i ca t i o n s .
PART I I I
B I BL I OGRAPHY
113
B I BL I O GRAPHY
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K. ,
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C h a nd l e r , A l fred D .
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,
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1 14
Myers , S . , 1 9 7 7 ( No vember ) , Dete rm i n a n t s of c o rporate b o r rowi n g , J o u r
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W i l l i amson , 0 . , 1 9 7 3 { May ) , Ma r kets a n d h ie r a rc h i e s : Some e l eme n t a ry
c on s i de ra t i o n s , Ame r i c a n E c o nomi c R e v i ew 63 ( 2 ) , 3 1 6- 3 2 5 .
W i l l i ams o n , 0 . , 1 9 8 1 { De cembe r ) , T h e modern c o rpora t i o n : O r i g i n s , e vo
l u t i o n , a t t r i b u tes , The J o u rn a l o f Econom i c L i t e ra t u re 1 9 , 1 5 3 7 1 5 68 .
W i l l i amson , 0 . , 1 97 5 , Ma r kets a n d h i e r a rc h i e s :
i mp l i ca t i o n s , New Yor k : Free P re s s .
Ana l y s i s a n d a n t i t ru s t
W i l s o n , R . , 1 9 7 5 ( Sp r i n g ) , I n t e r n a t i o n a l econom i e s o f s c a l e , The Be l l
J o u r n a l o f Eco n omi c s 6 { 7 ) , 184- 1 9 5 .
115
V I TA
George P . Tsetsekos wa s born i n Nafpl i on , Greece o n December 2 ,
1 954 .
He g ra d u a t e d f rom the Nat i on a l Tec h n i c a l Un i v e rs i ty o f Ath e n s
( Metsov i o n Po l yte c h n i c ) wi t h a d i p l oma i n E l e c t r i c a l a n d Mechan i c a l
E n g i nee r i ng ( 1 9 7 9 ) .
He rece i v e d h i s M . B . A . i n F i n a n c e f rom W r i g h t
S tate Un i v e r s i ty i n Aug u s t 19 8 1 , a n d e n t e red t h e docto ra l p ro g ram
i n F i n a n c e a t The U n i ver s i ty o f Tennessee , Knox v i l l e , i n S e p tembe r
1 98 1 .
Cu r re n t l y h e i s o n the Fi n a n c e fac u l ty at t h e Ame r i c a n
Un i ve rs i ty , Wa s h i n g to n , D . C .
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