Corporate Governance theory explains how directors behave when making decisions regarding the company. And explain why investors act the way they do. We have discussed agency theory and agency cost. This article focuses on transaction cost theory.
What does transaction cost theory mean
Transaction cost theory explains the decision-making process on whether to outsource an aspect of the company's operations or build it in-house. The company director will definitely choose the least expensive option.
For example, a company's operation involved outsourcing semi-finished goods from suppliers. This means that a few tasks will be done to put the goods into salable condition. However, the company will have to consider the economic and accounting costs of doing so.
Therefore, if outsourcing is cheaper then the company will go for it. However, other factors might be considered. Failure by the suppliers to deliver the semi-finished products on time. Also, getting the right quantity of materials supplied to meet demand.
Management may determine that the cost of outsourcing a portion of the operation is not beneficial compared to the cost. As a result, they built the portion in-house. Building internally means the company has to improve its internal structure to match the current growth plan.
Applying Transaction Cost Theory to Corporate Governance
Transactional cost theory explains why a decision by a director impacts the company and investors. Generally, directors make decisions to benefit the company.
Directors will choose a cheaper alternative because it will benefit the company. To illustrate, instead of engaging in research and development of a new product, a company's directors may prefer a merger and acquisition deal of another company that produces the product. This is cheaper for the director but will not benefit the shareholders.
How? Mergers and acquisitions involve huge cash outflows. Therefore, the amount of free cash flow available to pay dividends will fail. Therefore, lower dividends will be paid to shareholders. However, directors prefer celebrating a new growth milestone of the company.
In final words, transaction cost theory helps finance professionals to understand the different views of directors and investors in business deals. Top management will always favour their ego more than the shareholders. There is a need to always align their goals with those of investors.