Firm Size, Corporate Debt, R&D Activity, and Agency Costs: Exploring Dynamic and Non-Linear Effects

This paper empirically investigates firm-specific determinants of agency costs, a relatively new and unexplored area in corporate finance. We estimate dynamic agency costs models, linking debt, firm size, and R&D activity to agency costs for a panel of U.S. information and communication technology (ICT) firms over 1990-2013. We adopt the Blundell and Bond (1998) two-step system GMM technique, which explicitly accounts for persistence, endogeneity, and unobservable firm heterogeneity. We provide the first evidence that our inverse proxy for agency costs, namely asset turnover (Ang, et al., 2000), exhibits an inverted U-shaped relationship with debt and a U-shaped relationship with firm size and R&D activity. These findings imply that agency costs experience a minimum value (in case of debt) and a maximum value (in case of firm size and R&D activity) and, therefore, that agency costs are higher at both low and high levels of debt, and lower at both low and high levels of firm size and R&D activity. We find that the level of debt of the average firm in the sample falls below the level that minimizes agency costs. We also document that, consistent with the agency literature, short-term debt provides an additional effective monitoring mechanism to alleviate agency costs. Our findings reveal that agency costs are dynamic in nature, mean-reverting, and persistent over time. This notion confirms the Florackis and Ozkan (2009) conjecture that managers behave as though an optimal level of agency costs exist that they pursue. Finally, we find a positive association between firm profitability and agency costs and a negative association between agency costs and firm growth. Extensive additional analysis confirms the robustness of our results.