Agency theory is related to the behavior of two interested parties of the firm, like owners and managers. An agency problem results when managers as agent for owners place personal goals ahead to corporate goals.
Meaning of Agency Theory
Agency problem is a situation in which the interests of the principal (shareholder or owner of a business) and the agent (a manager or board of directors) are not aligned.
Agency problem occurs when the agent is entrusted with acting on behalf of the principal and making decisions that are in the best interests of the principal, but the agent instead acts in their own self-interest or the interests of another party.
The agency problem can arise business corporations, partnerships, finance, marketing, planning and other business operations.
Good corporate governance policies, performance incentives, and oversight from external parties can help resolving the agency problem.
Definition of Agency Theory
An agency problem is a potential conflict of interests that can arise between a principal and an agent.
- Agency problem is the potential conflict between principals (shareholders) and agents (managers). – C. P. Jones
- Agency problem is the likelihood that managers may place personal goals ahead of corporate goals. – L. J. Gitman
- The lack of perfect alignment between the interests of managers and shareholders results in the agency problem. – Prasanna Chandra
- Agency theory is a branch of economics relating to the behavior of principals (such as owners) and their agents (such as managers). – Van Home
Type of Agency Problems in Financial Management Context
Financial managers can be viewed as agents of the owners who have hired them and given them decision making authority to manage the firm. Most financial managers would agree with the goal of owner wealth maximization.
In practice, managers are also concerned with their personal wealth, job security and others benefits. However, managers may have personal goals that compete with shareholder wealth maximization and agency theory deals with such potential conflicts of interest
From this conflict of owner and personal goals arises that has been called the agency problem. With in the financial management context, the agency problems are those:
- Conflict between stockholders and managers.
- Conflict between stockholders and creditors.
- Conflict between owners and other parties.
Resolving the Agency Problem
From the conflict of management objective of personal goals and maximizing owner’s value arises the agency problem. The agency problem can be minimized by acts of
- market forces, and
- agency costs.
Market forces act to minimize agency problems in two ways:
1. Major Shareholders:
To exercise the major shareholders legal voting rights, the large, institutional shareholders communicate with and exert pressure on, corporate management to perform or face replacement.
2. Threat of Takeover
The constant threat of a takeover would motivate management to act in the best interests of the owners despite the fact that techniques are available to define against a threat takeover.
The cost occured by stockholders to minimize agency problems is called agency cost. Agency cost arises by shareholders to prevent or minimize agency problems and to work towards the maximization of shareholders’ wealth.
To minimize agency problem, the owners have to incur four types of cost, which are:
1. Monitoring Expenditures
The monitoring outlays relate to payment for audit and control procedures to ensure that managerial behavior is tuned to actions that tend to be in the best interest of the shareholders.
2. Bonding Expenditures
The firm pays to obtain a fidelity bond from a third-party bonding company to the effect that the latter will compensate the former up to a specified amount for financial losses caused by dishonest acts of managers.
3. Opportunity Costs
Such costs result from the inability of large companies from responding to new opportunities. The management may face difficulties in seizing upon profitable investment opportunities quickly.
4. Structuring Expenditures
The most popular, powerful and expensive method is to structure management compensation to correspond with share price maximization. The objective is to give managers incentives to act in the best interests of the owners. The two key type’s compensation plans are:
- Incentive Plans: The most popular incentive plan is the granting of stock options to managers. These options allow managers to purchase stock, if the market price rises z managers will be rewarded.
- Performance Plans: The forms of performance-based compensation are cash bonuses, cash payments tied to the achievement of certain performance goals.