Central to the theory of agency is the notion that firms will use optimal levels of contracting, monitoring and bonding to reduce agency costs. However, there are other ways by which agency costs may be controlled.
a) Since total agency costs increase with the level of outside financing, and firm value is maximized when agency costs are minimized, a simple method of eliminating agency costs is to only use internal financing. Why would the original owner/manager (entrepreneur) ever use outside financing?
b) Consider a world where the assumptions of the Capital Asset Pricing Model hold. How are agency costs controlled in a “CAPM world?”
c) How can the financial markets reduce the total agency costs of the firm?