Consider a firm which is initially 100 percent owned by a manager. The managers

wealth, W, consists only of the market value of the firms equity. The total amount of

the firms resources is $1 million. The manager will use some of the firms resources

for his/her own perquisite consumption, F, which is completely unproductive. That

is, $1 perquisite consumption by the manager would result in $1 reduction in the firm

value. The manager has a utility function, U(F,W), which is increasing and concave

in both F and W. The managers utility function is publicly known, but his/her

perquisite consumption is unobservable by others.

(a) Show graphically and explain in words how the owner-manager optimally chooses

his/her perquisite consumption.

(b) Now, the owner-manager wants to reduce his/her ownership of the firm from

100% to 51%. The manager thus sells 49% of the firms shares to new sharehold-

ers who are willing to purchase the shares as long as they expect to break-even at

the zero riskless rate of interest. Show that if the new shareholders naively con-

jecture that the owner-manager remains to consume the same amount of perks

as that characterized in part (a) and price the shares accordingly, they will suffer

a loss.

(c) Who would bear the agency costs of outside equity? Why?