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Abstract

This paper provides a critical review on the relevance and impact of agency problems and its impact on the borrowing levels of firms. We provide a brief look at the fundamental theoretical predictions from a basic framework established in the literature. Furthermore, we discuss the implications of the conflicts between managers and shareholders as well as shareholders and debtholders. The empirical literature provides some interesting insights on the potential mechanisms that can be used to reduce agency problems which range from managerial incentives, concentration of shareholders as well as the level, nature and maturity of debt. The findings are however inconclusive on the ability of such mechanisms to effectively control agency problems and subsequently reduce agency costs. Thus the issues highlighted remain unresolved and leaves ample room for future researchers.
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Agency Problems and its Impact and Relevance on
Firms Borrowings
Hafezali Iqbal Hussain
Universiti Kuala Lumpur Business School
Mohd Farid Shamsudin
Universiti Kuala Lumpur Business School
Azlan Ali
Universiti Kuala Lumpur Business School
Milad Abdelnabi Salem
Universiti Kuala Lumpur Business School
Sulaiman Sajilan
Universiti Kuala Lumpur Business School
Nursyuhadah Abdul Rahman
Universiti Kuala Lumpur Business School
Nur Syairah Ani
Universiti Kuala Lumpur Business School
ABSTRACT
This paper provides a critical review on the relevance and impact of agency problems and its
impact on the borrowing levels of firms. We provide a brief look at the fundamental
theoretical predictions from a basic framework established in the literature. Furthermore, we
discuss the implications of the conflicts between managers and shareholders as well as
shareholders and debtholders. The empirical literature provides some interesting insights on
the potential mechanisms that can be used to reduce agency problems which range from
managerial incentives, concentration of shareholders as well as the level, nature and maturity
of debt. The findings are however inconclusive on the ability of such mechanisms to
effectively control agency problems and subsequently reduce agency costs. Thus the issues
highlighted remain unresolved and leaves ample room for future researchers.
Keywords: Agency conflicts, shareholders’ wealth, borrowing
INTRODUCTION
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The literature in this area can be traced back to times of Adam Smith who noted that when
‘joint-stock’ companies were managed by people, who did not own them, there would be a
conflict. This conflict is often referred to as the agency theory and describes the agent-
principal relationship. In the modern corporation, the agent (the management) works on
behalf of the principal (the shareholders) who does not have the capacity or means to
scrutinise the actions of the agent, even if they had the incentive to do it. The problem that
arises here is that there may be a conflict in the objectives of the managers and the owners.
The owners would like to see the value of the firm maximised. Meanwhile, the management
would be making decisions to fulfil their own set of objectives that may include a guarantee
of their current job and position, reducing the workload by investing in projects that are less
complicated or require less attention and also favouring projects that have lower payback
period which could mean a more secure alternative.
Managers have every incentive to consume corporate wealth since the costs of such
consumption is not borne by himself. Seminal work in this area that relates to corporate
financing behaviour indicates that the principal can limit the divergences from his interests by
providing appropriate incentives (Jensen and Meckling 1976). The principal would also have
to incur monitoring costs to ensure that the agent does not redirect valuable resources from
the company to his own benefit. In today’s world, the shareholders are dependent on the
accounting reports to know what exactly the value of the firm is worth. However, these
reports are subject to manipulation by the agents (management) as observed in the accounting
scandals around the globe. Jensen and Meckling (1976) also state that it would be impossible
to get this done at zero costs and fittingly define agency costs to be inclusive of monitoring
expenditures by the principal, the bonding expenditures by the agent and the residual loss that
is a result from the excessive perks enjoyed by the management of the company.
Our paper proceeds as follows: the next section introduces the fundamentals of agency
problems. Following that, we discuss the relevance of agency problems from two different
perspectives, namely the conflicts between managers and shareholders as well as the conflict
between shareholders and debtholders. Lastly, we provide a discourse on the impact of these
conflicts on firms’ borrowings as evidenced in the empirical literature.
THE FUNDAMENTALS OF AGENCY PROBLEMS
Taking into consideration the expected behaviour of managers based on their incentive to
transfer wealth from the company to themselves, the price of new equity would be discounted
to take into consideration the costs of monitoring such behaviour. Given this scenario,
managers would be motivated to issue debt. However, issuing debt to finance investment
would also incur agency costs. The conflict that arises from this sort of financing would now
be due to the conflict between the debtholders and the shareholders. When a company issues
more debt, the managers are given the incentive to invest in riskier projects. If these projects
were successful, the shareholders would reap the benefits of such projects. On the other hand,
if the project were to fail, the shareholders downside of the losses incurred would be limited
given that they are protected by the limited liability whereby a firm is an entity of its own and
separated from the owners.
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Debtholders on the other hand would not be enjoying the benefits of a success since their
returns would be constant but would be exposed to the full downside of the situation if the
risky project were to fail and cause the firm to go bankrupt. Assuming that debtholders are
rational, they would incorporate a premium into the necessary compensation they would
expect to receive given the probability of bankruptcy would increase if the firm were to issue
more debt. In practise this is translated to higher interest payments, thus increasing the costs
of debts. Given this scenario, Hunsaker (1999) includes the opportunity costs caused by the
impact of debt in the investment decisions of the firm; the monitoring and contractual
expenditures by the debtholders and the managers as well as the costs associated with
bankruptcy and reorganisation as the agency costs of debt.
The duration of the debt contract serves as a tool that can be used to mitigate the agency costs
of debt financing. This is because the extent of this problem depends largely on the length of
the agreement. In other words, debt maturity plays an important role reducing the problem.
The longer the duration of the loan, the more opportunities the shareholders have to profit at
the expense of debtholders. Johnson (2003) shows that agency costs are smallest for short-
term debt. Another possible step that debtholders can take to protect themselves would be to
include debt covenants (Smith and Warner, 1979). This can be in the form of a specific set of
instructions that will be laid out in the contract and is a condition of giving out the funds to
the company. The covenants may range from the type of investment that the firm is allowed
to make to the amount of dividend that is paid out to the shareholders. However, Smith and
Warner (1979) also argue that these covenants also limit the power of management’s decision
and may be counter-productive to the overall value of the firm.
CONFLICTING INTERESTS BETWEEN SHAREHOLDERS AND MANAGERS
There are quite a number of possible scenarios or situations in today’s business world that
would give rise to the conflict of interests between shareholders and managers. The first
happens when managers put in lower levels of efforts since the cost of this inefficiency will
not be borne by themselves but by the shareholders. This is of course given that the levels of
wages do not reduce as well as pointed out in Jensen and Meckling (1976). Another scenario
is when managers are reluctant to accept projects that are risky and opt for less risky options
as well as lower levels of debts (Hunsaker 1999). In cases where there are inefficiencies,
management will tend to resist takeovers even if it is in the best interest of the shareholders.
This is because managers will try their best to minimise the likelihood of employment
termination (Garvey and Hanka, 1999). In Harris and Raviv (1990) managers are said to
always want to continue with the firm’s current operations even if liquidation of the firm is
preferred by the investors. Managers may also be keen to reinvest all available funds even if
paying out cash serves the interest of the shareholder better (Stulz, 1990).
Given these different possible conflicts that arise in the agent-principal relationship that
reduces shareholders value, it is important to be able to discipline the actions of managers via
different governance mechanisms. These mechanisms could at the very least minimise these
problems and in turn reduce the associated agency costs. Jensen (1986) proposes that to
reduce inefficient behaviour on the side of managers, the free cash flow that is made available
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to them is reduced. This is argued because management would be interested in increasing
firm size whereas shareholders ultimate motif is to maximise the value of their shares.
Managers would tend to finance less profitable projects with internal funds, which is subject
to less scrutiny and monitoring as compared to external funding. Thus, shareholders can opt
for two possible actions to prevent this behaviour. The first would be to demand the increase
in the levels of dividends. The second possibility would be to increase the levels of leverage
in the firm. This would in turn reduce the free cash flow that is available to managers to
invest in unprofitable expansions. Hunsaker (1999) also notes that an increase in leverage
would increase the possibility of bankruptcy, thus give managers the incentive to consume
fewer perks and increase effort levels.
The use of debt as a disciplining tool is also proposed in Haris and Raviv (1990). In this
model, reduces the agency costs by giving the debtholders the option to force liquidation if
cash flows are poor. However, in this model, the introduction of debt also causes another
form of cost, which is the cost of information in the process of liquidation. A firm will then
reach an optimal capital structure based on the trade off between the benefit of debt which
allows for liquidation versus the cost of investigation. In Stulz (1990), on the other hand, debt
works to as a disciplining tool in a different way. In this model, as in Jensen (1986), debt
reduces the free cash flows available to managers. This model also proposes an optimal
capital structure that is obtained by trading off the benefits of debt with the costs of debt. The
cost of debt is that debt payment may more than exhaust free cash. This would lead to a
scenario of underinvestment where the necessary cash required for profitable investments
would not be available to managers.
Several studies also propose the use of convertible debts to control the behaviour of managers
(see Jensen and Meckling, 1976, Green, 1984 and Smith and Warner, 1979). The logic
behind this argument comes because this tool allows for the use of debt to control managerial
behaviour and at the same time allowing investors to participate in the possibility of increased
profits via conversion and thus enjoying the upside of the payoff in terms of capital gains. If
the firm has huge potential for growth, then it is possible that the managers would tend to
overinvest. Thus to reduce the problem of overinvestment, it is better to introduce convertible
debt since ordinary debt would limit the growth potential. Thus, firms with growth
opportunities should have a positive relationship with convertible debt and a negative
relationship with ordinary debt.
A concentrated level of debtholders would also have the incentive and the ability to monitor
managerial behaviour to the extent of reducing the agency costs. The free rider problem that
arises from one individual bearing the costs and all of the other investors sharing the benefits
of the monitoring and controlling managerial behaviour can be resolved if the debtholders
were concentrated (Stiglitz, 1985) According to this view, this costs can be borne by lenders,
especially banks in order to effectively exert control over managerial behaviour. Banks have
the incentive to monitor the possibility of default and managers are motivated to avoid
situations of default. Thus, Berglof (1990) argues that lower levels of debt should be
observed in firms with dispersed creditor structure as opposed to concentrated creditor
structure. Agency costs can also be reduced through the increase of managerial ownership.
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Kim and Sorensen (1986) suggest that lenders would be able to have a clearer view of
managerial actions that reduce the value of debt if management concentration were higher
and also be more willing to negotiate to increase the levels of equity to balance out the risks
of increase levels of leverage.
CONFLICTING INTERESTS BETWEEN SHARHOLDERS AND DEBTHOLDERS
Any firm that has leverage in its balance sheet would be confronted with this type of agency
problem. This conflict exists if the investment decision has different consequences on the
value of equity and the value of debt. According to Jensen and Meckling (1976), managers
who are working for the interests of shareholders, will tend to over-invest. The over-
investment problem is especially true when the firm is facing financial distress. There will be
some amount of information asymmetry whereby managers will have the advantage of
knowing whether the firm will be facing financial distress in the future or not. In such cases,
the managers would have the incentive to invest in risky projects that they would not have
accepted otherwise. The downside of this scenario is borne by the debtholders but the upside
is enjoyed by both the shareholder as well as the debtholders. This is also commonly referred
to as asset substitution where shareholders will have the incentive to substitute risky
investments for safe ones after issuance of debt.
Another possible form of conflict is when the exact opposite behaviour occurs when the firm
is facing financial distress. During such circumstances, shareholders would again be having a
conflict of interest with debtholders. However, instead of accepting risky projects, they will
be declined to finance new, positive NPV projects. In such a situation, there would be an
under-investment problem. The project would increase the value of the debt but would not
increase the value of the equity. This situation is known as debt overhang (Myers, 1977). The
reluctance to accept the project would be costly for debtholders and be detrimental to the
value of the firm. According to Myers (1977), this cost is higher for firms that are likely to
have profitable future growth opportunities requiring large investments.
There is also a possibility of conflict when managers would sell the assets of the company
and use the proceeds to pay out dividends to the shareholders. This would leave the
bondholders with valueless assets if the company were to be liquidated and thus their claims
would be worthless (Smith and Warner, 1979). Smith and Warner (1979) also identify
another source of conflict between debtholders and shareholders which is the claim dilution.
When bonds are issued, they are normally priced assuming that the firm will stick to a
particular level of leverage. Thus, in the event where managers decide to increase their
leverage levels and issue more debt, the value of the bonds would have decreased since their
claim to the assets of the company would have decreased. Galai and Masulis (1976) in their
model show that the transfer of wealth from the shareholder to the bondholder can result from
an increase in the level of risks in the firm, an increase in the leverage levels and a payout to
the shareholder. However, Jensen and Meckling (1976) argue that investors are well aware of
these conflicts and the costs associated with them and thus will discount any bonds issued.
Thus shareholders would not benefit from such actions.
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Debtholders are aware of this conflict and thus the use of convertible debt (as with the case of
conflict between shareholder and managers) reduces the costs of conflict between
shareholders and debtholders. This is because the option that is given to bondholders to
convert their bonds to shares would allow them to share in any possible wealth transfer that
might occur. Thus shareholders have less incentive to act in such ways (Green,1984 and
Masulis, 1983). Based on this logic, the discount applied by the investors on bonds issued by
the company would be reduced. Thatcher (1985) supports this notion and shows that the issue
of convertible debt reduces this sort of agency problem.
Managerial reputation also plays a role when analysing the conflict of interests (Diamond,
1991). According to Diamond (1991), managerial reputation is an important aspect that
investors look at when determining the borrowing rate. Firms can be classified into safe and
risky categories based on their choice of investments. Firms that invest in safe assets will
have a lower risk of default. On the other hand, firms that invest in risky projects would have
a higher risk of default. Investors, being outsiders to the firm, are only able to observe
default. Thus, the longer the firm is able to remain default free, the better its reputation. This
leads to a lower borrowing rate. Based on this, it can be suggested that older and more
established firms will opt for safer and less risky options because they would be trying to
maintain their reputation. Younger and relatively unknown firms would be inclined to choose
risky projects with higher returns in the short run. In the long run, once these firms become
profitable and reputable, they would then switch to less risky projects. Based on this,
Diamond argues that older firms tend to have lower levels of debts.
Rational managers would try to enhance their personal reputation in managing the firms.
Their reputation is closely tied to the perceived human capital value that they add to the
company. Thus, a manager would opt for investment decisions that would build their
reputation (Hirshleifer and Thakor, 1992). Their compensation packages would be tied to the
successes and failures of the projects that they choose to invest in. Therefore, managers
would have the incentive to go for projects that have the highest possibility of success even
though they may have poor cash flows or may not be the best (optimal) choice. Hirshleifer
and Thakor (1992) term this moral hazard as an excessive level of managerial conservatism
and can cause the firm value to be lowered. However, this behaviour that results in sub-
optimal value of the firm does have a plus side. This is because managers that would
interested in protecting their reputation would not choose the risky projects. The result from
this would be a reduced level of expropriation of debtholders by shareholders, causing a
reduction in the cost of borrowing. Given this, the company would be able to have higher
levels of leverage than otherwise, resulting in greater tax savings due to the tax deductibility
of interest payments.
EMPIRICAL STUDIES ON AGENCY PROBLEMS
Managers as agents of shareholders act on their behalf to make decisions in the day to day
running of the company. However, to evaluate the effectiveness of this decision making is
extremely difficult. This is due to the complexity in measuring the agency costs involved in
the dynamics of today’s modern corporate. Ang et. al. (2000) provide a measure of agency
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costs for equity for companies under different ownership structures. This is done by
comparing the performance of such firms with a base firm which is hypothetical in nature as
a benchmark. This firm is 100% manager owned. The analysis is done for small firms and
shows that agency costs are higher for firms with higher levels of non-managerial ownership.
Agency costs can be lowered by via greater monitoring, mainly by banks and increasing
manager’s ownership share. Habib and Ljungqvist (2005) further compare this benchmark to
provide a direct estimate of agency costs in publicly held corporations using the Tobin’s Q as
a measure. The results show that due to agency costs, the firm is about 16% below its
benchmark value which translates into $1432 million. Thus the reduction of this significant
amount of costs would see the firm performance improve in comparison to its peers in the
same industry or class.
Increased levels of managerial ownership should lead to lower levels of agency costs. Thus, it
can be argued that leverage ratios can be explained by the agency costs reasoning. Kim and
Sorensen (1986) test this notion by dividing firms into groups of ‘insider’ and ‘outsider’.
Insider refers to firms where insiders own more than 25% of the firm, whereas outsiders are
defined as firms where insiders own less than 25% of the firm. Debt was measured as the
ratio of long term debt to total market capitalisation. The results show that insiders firms on
the average have significantly higher levels of debt ratios than outsider firms. Insider firms
are observed to have about 6-7% higher debt levels than outsider firms in the same industry.
The results also suggest that large firms with high levels of insider ownership tend to rely
more on long term debt. This could be due to insiders opting to issue to more debt to maintain
control over ownership. Debt is also preferred as a financing option since it does not carry the
high agency costs of equity. Another reason for this observation is that firms with higher
levels of insider ownership by itself would have lower levels of agency costs due to more
control in observing covenants and provisions that are part and parcel of debt as well as sub-
optimal levels of investment reducing the expropriation of debtholders. Chen and Steiner
(2000) also find a strong positive relationship between managerial ownership and leverage
levels thus lending support to the argument of lowering agency costs of debt due to sub-
optimal levels of investment reducing the asset substitution effect.
Shareholders would also be interested in reducing the agency conflict that gives rise to the
under-investment problem. This can be done by including some form of equity as a
compensation package to the management. Datta et. al. (2001) show that managers that have
some form of ownership tend to be involved in risk-increasing acquisitions that would benefit
shareholders as the increased risks would usually be accompanied by an increase in returns.
Ryan and Wiggins (2002) show that firms where managers compensation packages include
equity ownership tend to have higher levels of R&D investment. The findings also observe
the opposite where the R&D investment levels are lower for firms which do not have equity
ownership as a part of the management compensation packages. This shows that the firms
would have lower levels of growth potential. Overall, the empirical papers suggest that
agency costs can be lowered via managerial ownership, which causes the firm value to be
maximised.
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Agency costs also can be reduced by increased levels of ownership concentration. Ownership
concentration can also be observed via institutional ownership. Firth (1995) studies the effect
of institutional ownership and managerial ownership on capital structure decisions. The
variables used to reflect the composition of ownership in this study are the year-end market
value of the management’s shares, percentage of ownership by management and percentage
of ownership by institutional investors. The market value of management’s shares is found to
be negative and significantly related to the debt-equity ratio. The percentage of ownership by
management is also negative but insignificant. This lends support to the notion that mangers
would try to enhance their reputation to influence the perceived value they add to the
company as the human capital. The percentage of ownership by institutional investors on the
other hand is found to be positive and significant to the debt-equity ratio. This shows that
there is a reduction in the agency costs and thus leads to a higher level of gearing by the firm.
Agrawal and Mendelker (1992) also find that institutional ownership leads to better
monitoring and thus reduces agency costs that affect firms.
The reduction of agency costs of debt via concentrated ownership is further supported by the
work of Amihud et. al. (1990). This is due to the reduction in monitoring costs thus reducing
the agency costs associated with debt. Shleifer and Vishny (1986) also find that large
shareholders play an active role in monitoring management. The voting power that comes
along with significant levels of ownership also influence the ability of large shareholders to
reduce agency costs. The existence of such a strong voting power would tend to motivate
managers to perform optimally as the treat of losing their jobs would be perceived to be real.
Denis and Sarin (1997) show that firms with higher levels of concentrated or large
shareholders have a higher level of executive turnover. Denis and Serrano (1996) also show
that firms with large shareholders tend to outperform firms with dispersed ownership.
Overall, the effective role of large-block shareholders of monitoring and exerting a perceived
threat to manager’s job safety, reduces the agency costs and is enjoyed by all shareholders.
Empirical studies however are unable to conclusively establish the effect of concentrated
shareholders on agency costs. Large shareholders should reduce agency costs and thus firms
with a higher level of large shareholders should have higher levels of leverages. Zeckhauser
and Pound (1990) assess the impact of large shareholders towards corporate performance.
Large shareholders should be able to gather information for monitoring purposes more
efficiently than smaller shareholders. Thus, the leverage levels of firms with at least one large
shareholder should be higher than that of firms without any large shareholders. The reason
for this expected observation is that the firms would be able to exploit the benefits of debt
more extensively. The results show that there is no significant difference in leverage ratios of
these 2 groups of firms. This shows that large shareholders conduct the monitoring function
only for equity owners and do not have an impact on debtholders. The notion of large
shareholders reducing agency costs however has an agency conflict of its own. Large
shareholders may vest personal interests in their holdings and choose to pursue actions that
wouldn’t coincide or be aligned to the interest of minority shareholders (La Porta et. al.
1998). They would be able to utilise the assets of the companies for their own personal
purpose which would then be done at the expense of the minority or smaller and dispersed
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shareholders. In this cases, the levels of agency costs may in fact be higher with large
shareholders rather than without them. Classens et. al. (2002) show that a greater
concentration of voting rights has a negative effect on the firm value. These studies show that
large shareholders may enjoy a private benefit that would in turn increase the agency costs
instead of minimising the costs of the conflict.
Studies also focus on the impact of concentrated shareholders on the R&D investment, which
is generally seen as a growth potential and in turn influences the value of the firm. The
literature however has mixed results regarding to the relationship between large blockholders
and the R&D activities. The first strand of literature has found that concentrated ownership
encourages R&D investments (such as Wahal and Mcconnel, 2000 and Hosono et. al., 2004).
There are also studies such as Yafeh and Yosha (2000) which find that this relationship is
negative. On the other hand, some empirical studies find that concentrated shareholders have
no impact on R&D activities at all (see Holderness and Sheehan, 1988 and Francis and
Smith, 1995). Recent studies have started focusing on the type of block shareholders that
influence the R&D expenditure policies of the firm. Hosskisson et. al. (2002) found that the
type of concentrated ownership influences the R&D investment policy that the firm decides
to pursue. The results show a significant difference between the firms that had pension funds
and professional investment funds as the main shareholders. Firms in the latter category
pursued a more aggressive and thus highly intensive R&D expenditure.
CONCLUSION
Our paper reviews the relevance of agency problems and its implications on firms’
borrowings. We provide a summary of the theoretical development in the area and provide a
short discourse on the empirical literature which tests the framework. We discuss the
framework by looking at agency conflicts from two different perspectives. Initially, we
dissect the issue at hand by looking at the conflicts that arise between managers and
shareholders. Furthering the argument, we analyse the conflicts that arise between
shareholders and debtholders. Furthermore, our paper looks at the empirical literature that
generally finds some support on the mechanisms that are used to control agency problems
and costs. However the literature also provides some contention and the findings remain
inconclusive. Our paper highlights this gap in the literature which provides some useful
insights and direction to future studies.
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... Jensen & W.H. Meckling (1976), and other scholars, originated from the separation between ownership and control in modern companies that issue shares. This separation, when combined with a truly inability to determine contracts, will give agents or managers the opportunity to pursue activities that will benefit themselves at the expense of their principal or owner (Jensen & Meckling, 1976;Laiho, 2011;and Hussain et al., 2015). ...
... This failure is the most important cost that results from principal and manager conflicts and is known as the agency problem. Agency Theory views corporate management as an agent for shareholders who will act with awareness for their interests, not as a wise and prudent and fair party to shareholders as assumed in the previous theory (Jensen & Meckling, 1976;Laiho, 2011;and Hussain et al., 2015). ...
... The number of board of directors plays an important role in increasing effectiveness and efficiency in the company, the greater the board of directors can improve control and supervision so as to minimize agency problems. Agency problems in the company arise, due to differences in interests between managers as agents with company owners, these differences in objectives will ultimately have an impact on the company's objectives, especially cash holdings (cf Jerzemowska, 2006;Hussain et al., 2015;and Acero & Alcalde, 2016). ...
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... Jensen (1986) proposes that to decrease inefficient behaviour on the side of managers, the free cash flow that is made available to them should be reduced. Hussain et al. (2015) argued that shareholders could opt for two possible actions to prevent inefficient behaviour. The first would be to demand an increase in the levels of dividends. ...
... This indicates that the cost of issuing long-term debt is lower for compliant firms. Our findings to however indicate that non-compliant firms would be more inclined to maintain short-term debt in order to reduce agency costs, suggesting the potential for greater agency costs in Shari'ah compliant firms (Hussain et al., 2015b). In addition, greater reliance on long-term debt reduces the frequency for renegotiation of contracts which leads to potentially greater levels of information asymmetry for compliant firms relative to their non-compliant counterparts. ...
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