Impact of ownership structure on agency costs - a study of the agency cost hypothesis in an Indian context

Abstract

Corporate governance is the system of control mechanism through which the suppliers of finance to a corporation ensure adequate returns on investment. The principle of corporate governance lies within the separation of ownership and control, the agency cost resulting in a divergence of interest between the owners and the managers of a firm. Agency costs represent an important aspect of corporate governance in financial and non-financial industries. Te separation of ownership and control in a professionally managed firm may result in managers indulging in practices that are contradictory to the goals of maximizing firm value. Theory suggests that the choice of capital structure may mitigate agency costs. Under the agency cost hypothesis high leverage or a low equity reduces agency costs and increases firm value by constraining the managers to act in the interest of the shareholders. This is valid under the absence of excess debt and bankruptcy costs. It is hypothesized that the ownership structure is also a significant determinant of firm performance. The incentive hypothesis states that when managers of a firm share a part of the ownership they strive to maximize value to ensure high returns. This is applicable only to a certain proportion of ownership share beyond which the entrenchment effect leads to divergent strategies which are not value maximizing. The ownership structure in India has undergone a transition from the family controlled organizations during the license raj period to widely held corporations. Corporate governance has assumed significance in the Indian corporate world as global economies have opened markets to Indian firms and increased competition from multinational companies. We aim to explore the agency cost hypothesis by examining relationship between ownership structure and firm value, in the Indian context, through a study of financial performance of a selection of firms. The study will focus on the prevalent literature oncorporate governance, agency costs and the impact of ownership structure on firm performance and other important parameters like risk. We also aim to build a model using panel data of a selection of Indian firms to observe the relationship between firm performance and ownership structure.