The quote shows a strong relation to the efficient market hypothesis (EMH), as it implies that the costs of capital are dependent from the amount of information given by the company.
According to my opinion, agency theory is a good explanation for costs of capital. Agency theory defines contracts as under which one party – called principal – engages another party – called the agent – to perform service on the principal’s behalf. Concluding, the principal delegates decision-making authority to the agent.
Both sides of the contract are utility maximisers and the agent will not necessarily act in the principal’s best interests. This leads to the rise of agency costs. Agency costs are the welfare reduction by the principal due to the divergence of the interest. There are three agency costs (1) monitoring costs, (2) bonding costs, and (3) residual loss. (1) Monitoring costs are the costs of monitoring agent’s behaviour. They are expenses of the principal to measure, observe, and control the agent’s behaviour. Good examples for monitoring costs are auditing costs. To protect themselves of huge monitoring costs principals are bearing the costs to agents. An example can be given in lending: A high-risk company has high monitoring costs, which leads to a high interest rate. Another example would be the reputation of the manager: Has he got a bad reputation, than his salary would be lower than usual. Agents try to reduce monitoring costs by installing mechanisms to guarantee that they will behave in the interest of the principal or by proposing to compensate principals for their losses. (2) The mechanisms mentioned above are bonding costs, because they are the costs of bonding the agent’s interest to the principal’s. Quarterly financial reports are bonding costs, namely the time and effort invested to generate the financial report. Agents will normally weigh bonding costs with monitoring costs and chose the cheaper alternative. (3) Despite bonding and monitoring costs, it is still likely that agents’ interests will not correspond exactly with the principals’. If the manager is not motivated and does not invest his whole efforts, than his actual work output is lower than it would be, if his interests were exactly the same as principals’ interests.
EMH-theory solves who bears the agency costs to which amount. In strong efficient markets the agent will bear the cost fully: The costs of capital are higher, his reputation will decrease, and his career opportunities will also slacken. In semi-strong and weak efficient markets exists the incentive for agents to act opportunistic, since they do not fully bear the costs of their behaviour. If the users just get the information the agents allows them to receive, than the information are likely to be filtered in the agents interest.
As I have explained the fundamental prerequisite for understanding and evaluating the quote now, it is necessary to mention that it is not possible to measure the true financial performance of a company. Accounting is a social science and cannot be objective: “Accounting as a social science is bidirectional and does not have an objective and separate existence from accountants” (Godfrey-Jayne et al; 1997, p. 395). Accounting deals with measurements and should as good as possible enable users to determine the fair value: “The amount for which an asset could be exchanged between a knowledgable, willing buyer and a knowledgable, willing seller in an arm’s length transaction” (AASB 1013). This leads to the principle of presenting a true and fair view of the company. If this aim could be achieved, than investors should gain full confidence in the integrity of markets, reducing their monitoring and bonding costs, which should result into a reduction of the cost of capital.
But the production of accurate information is tricky, because...
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