agency theory. introduction agency theory provides the framework for discussing the relationships...

AGENCY THEORY

Introduction

Agency theory provides the framework for discussing the relationships that exist between the various interest groups in an organization.

It views the firm as a “composite unit” consisting of separate interest groups.

Each interest group pursues its own interest and ensures it stands at an advantageous position in relation to the firm.

Each individual group however recognizes the fact that its success is a function of the company vis-à-vis other companies in the same industry.

Agency theory

The theory brings out a clear exposition of the actions of some managers which are not in consonance with the actions they were to take, assuming shareholder’s wealth maximization objective is pursued.

Agency Relationship

Agency relationship exists when one person (or a group of persons) called the Principal, appoints another person called the Agent to perform some work on its behalf and gives the agent the appropriate decision-making authority.

In the context of Strategic Financial Management, such relationships occur, among others between: Shareholder’s and managers; and Creditors and shareholders

Agency Relationship

It is natural that where such relationship exists, there is bound to be conflict of interest which creates a problem known as agency problem.

The reason underlining the conflict in the case of shareholders-managers relationship is the separation of ownership and control.

Shareholders vs Managers

The reason underlining the conflict is the separation of ownership and control. This may arise in the following situations: Choice of Projects Appraisal Technique

In pursuit of their self-interests, managers may prefer projects with short lives against those with long lives. They may therefore want to use Payback technique instead of the superior Net Present Value technique.


Appraisal of Risky ProjectsFinancial managers may not want to undertake projects which bring substantial benefits to the owners, but are highly risky, because of the negative impact of this risk on their own financial position. However, this risk has presumably been well diversified away by the shareholders.


GearingFinancial managers may not want the company’s debt to be unduly large in relation to equities so as to reduce the financial risk of the company. Financial managers may however, by doing this, not be taking advantage of tax-deductible interest cost, where interest is treated by the tax authorities as a charge against profits.


Takeover bidsWhen a company is compulsorily taking over another company, the target company’s directors may be resisting such action in order to protect their own jobs; even though it will bring greater wealth to the existing shareholders.


Leveraged Buy-OutIn a leveraged buy-out, the company’s management borrows funds to purchase the outstanding shares of the company via a tender offer (an offer to buy the shares of a company directly from the shareholders). There is the possibility that managers might try to drive down the price of the company’s share just before the tender offer, so that they can buy the shares at a bargain price.


Dividend PolicyThis is where financial managers are pursuing an unduly conservative dividend policy: that is, trying to keep dividends at a level which is much lower than the normal level, given the industry norms. The question , however, is: can the funds not distributed be utilized better by the shareholders themselves, if received as dividends?


Disclosure of Information in the Financial StatementsThis is where financial managers “paint” the financial condition of the company via its balance sheet , rosier than what it really is. This is known as “window dressing” or, in a mild form, “creative accounting”. It is made possible by the open-ended nature of the choice of accounting policies, when directors prepare financial statements. For example, directors might want to defer certain type of expenditure (e.g. advertising) and capitalize it or put value on intangibles such as patents.


Ethics Top management might display certain unethical practices when it makes some decisions on operations. Typical examples of such practices are the degradation of the environment through pollution and testing of products on human beings.

Shareholders vs. Managers

Possible solutions Shareholders need to ensure that there is

“Goal congruence”. Goal congruence means convergence of the

interests of different groups such that the overall goal of the company can be achieved.

It means the need for shareholders to ensure that managers take actions in accordance with their expectations and in their best interest.


Possible solutions The actions necessary to achieve goal

congruence are as follows: Monitoring

The company needs to monitor every action of management. However, some costs known as agency costs would be incurred. This is an expensive way of ensuring goal congruence. Agency costs would include expenditure that is necessary to physically monitor the manager and expenditure to restructure the organization so that bad elements within the system are removed.



congruence are as follows: Monitoring

They also include opportunity costs arising from profits lost when managers take decisions as agents instead of as owner-managers; decision-making is slow in the former but fast in the latter.



congruence are as follows: Compensation via allocation of shares in

the companyIn this case costs might not be too prohibitive as managers would gear their efforts toward profitability and capital appreciation via cutting down operational costs including salaries and fringe benefits and taking less time off duty.


Possible solutions In between Monitoring and Compensation via

allocation of shares in the company are the following : Threat to Dismissal

This may not be effective as ownership in many big companies (where ownership and control are highly separated) is widely dispersed and shareholders often find it difficult to speak with one voice. Few shareholders attend the annual general meetings and, in any case, directors usually ensure they get enough proxies to support them at meetings. It should be noted however, that the presence of institutional investors could weaken the directors strength.



allocation of shares in the company are the following : Exposure to Take-over Bid

This could deter managers from taking actions that will be at variance with share price maximization. If the company’s earning potentials are being knowingly or unknowingly suppressed through bad policies and the share is consequently undervalued, in relation to its value, it may be exposed to hostile-take-over bid. The result is that some top managers might lose their jobs and the authorities of those remaining might be drastically reduced.



allocation of shares in the company are the following : Executive Share Option Scheme

This is a performance-based scheme that allows top managers to buy the shares of the company in future, at a price determined now. The belief is that this will motivate the managers to continually take actions that will be pushing up the share price: the option has value if the price of the share increases above the originally fixed option purchase price. It should be noted, however that this scheme may not be beneficial to managers in a period of market downturn.


Possible solutions In between Monitoring and Compensation

via allocation of shares in the company are the following : Performance Shares

These are shares given to top managers and linked to company’s performance as mirrored by its fundamentals – earnings per share, return on capital employed, return on equity, dividend per share and so on. This scheme is valuable to the extent that it is not affected by vagaries of the stock market.

Creditors vs. Shareholders

The agency problem of creditors and shareholders (with managers as agents) arises from two situations: Capital Investments

Creditors would not like a situation where the acceptance of a project will add greater business risk than is expected by them. If this happens, they will increase their required rate of return and the value of their outstanding debt will fall. The major concern of creditors here is that if risky project succeeds, creditors will only receive a fixed amount (interest income) and shareholders will take all the benefits’ whereas, if the project fails, they will share the losses with the owners.


The agency problem of creditors and shareholders (with managers as agents) arises from two situations: Gearing

Where the company increases its gearing (debt/equity) ratio to a level that increases financial risk to more than expected, the value of the existing debt will fall because the earnings and assets backing available for this debt will diminish as a result of the new issue of debt.


In – built SolutionShareholders do try as much as possible not to exploit creditors as such action may attract punitive high interest rates, restrictive covenants, restricted access to capital market, all of which may result in a fall in the long-term value of the company’s share. Shareholders would, therefore, want to continue to maintain good and cordial relationship with their creditors, as it is by doing so, that their wealth will be maximized.

agency theory. introduction agency theory provides the framework for discussing the relationships...

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