AGENCY RELATIONSHIP

Managers are empowered by the owners of the firm—the shareholders—to

make decisions. However, managers may have personal goals that compete
with shareholder wealth maximization, and these potential conflicts are
addressed by agency theory. An agency relationship arises whenever
someone, called a principal, hires someone else, called an agent, to perform
some service, and the principal delegates decision-making authority to the
agent. In financial management, the primary agency relationships are:

(1) Between stockholders and managers and

(2) Between stockholders and debt holders

Agency Conflict I: Stockholders versus Managers

A potential agency problem arises whenever a manager owns less than
100 percent of the firm’s common stock. If the firm is a proprietorship
managed by itsowner, the owner/manager will presumably operate so as to
maximize his or her own welfare, with welfare measured in terms of
increased personal wealth, more leisure, or more perquisites. However, if
the owner/manager incorporates thebusiness and then sells some of the stock
to outsiders, a potential conflict of interest immediately arises. Now the part–
owner/manager may decide to work lessstrenuously, because less of the
wealth produced by this labor will accrue to him or her. Similarly, the part–
owner/manager may take more perquisites, because some of his or her
costs will be borne by the outside shareholders. Finally, the part–
owner/manager will have an economic incentive to raise his or her
salary, bonus, and stock option grants as high as possible, because most of
the costs of such payments will be borne by outside stockholders.

In most public corporations, agency conflicts are important, because

their managers generally own only a small percentage of the stock.
Therefore, shareholder wealth maximization could take a backseat to
managers’ personal goals. For example, the extreme levels of executive
compensation paid by many firms in the last few years are hard to justify on
economic grounds. Also, studies suggest that some managers try to maximize
the size of their firms. By creating a larger firm, managers:

(1) increase their job security, because a hostile takeover is less likely;

(2) Increase their personal power and status; and

(3) Since compensation is positively correlated with size, justify a higher

salary and bonuses.

Managers can be encouraged to act in the stockholders’ best interests through

a set of incentives, constraints, and punishments. However, to reduce agency
conflicts, stockholders must incur agency costs, which include all costs
borne by shareholders to encourage managers to maximize the firm’s long-
term stock price rather than act in their own self-interests. Because
managers can manipulate the information that is available in the market, it is
critical that good incentive compensation plans be based on stock prices over
the long term rather than the short term. There are three major categories of
agency costs:

(1) Expenditures to monitor managerial actions, such as auditing costs;

(2) Expenditures to structure organizations in ways that will limit undesirable

managerial behavior, such as appointing outside investors to the board of
directors; and
(3) Opportunity costs that are incurred when shareholder-imposed
restrictions, such as requirements for stockholdervotes on certain issues,
limit the ability of managers to take timely actions that would enhance
shareholder wealth.

Agency Conflict II: Stockholders versus Creditors

In addition to conflicts between stockholders and managers, there can also be
conflicts between stockholders (through managers) and creditors. Creditors
have a claim on the firm’s earnings stream, and they have a claim on its
assets in theevent of bankruptcy. However, stockholders have control
(through the managers) of decisions that affect the firm’s riskiness. Creditors
lend funds at rates that are based on the firm’s perceived risk at the time the
credit is extended, which in turn is based on:

(1) The riskiness of the firm’s existing assets,

(2) Expectations concerning the riskiness of future asset additions,

(3) The existing capital structure, and

(4) Expectations concerning future capital structure changes. These are the
primary determinants of the riskiness of the firm’s cash flows, hence the
safety of its debt. Suppose the firm borrows money, then sells its
relatively safe assets and invests the proceeds in a large new project that is
far riskier than the old assets. The new project might be extremely
profitable, but it also might lead to bankruptcy. If the risky project is
successful, most of the benefits go to the stockholders, because creditors’
returns are fixed at the original low-risk rate. However, if the project is
unsuccessful, the bondholders take a loss. From the stockholders’ point of
view, this amounts to a game of “heads, I win; tails, you lose,” which is
obviously not good for the creditors. Thus, the increased risk due to the asset
change will cause the required rate of return on the debt to increase, which in
turn will cause the value of the outstanding debt to fall. Similarly, suppose
after borrowing, the firm issues additional debt and uses the proceeds to
repurchase some of its outstanding stock, thus increasing its financial
leverage. If things go well, thestockholders will gain from the increased
leverage. However, the value of the debtwill probably decrease, because now
there will be a larger amount of debt backedby the same amount of assets. In
both the asset switch and the increased leverage situations, stockholders
have the potential for gaining, but such gains are at the expense of
creditors. Can and should stockholders, through their managers/agents, try to
use such procedures to take advantage of creditors? In general, the answer
is no. First, creditors attempt to protect themselves from such actions by
including restrictive covenants in debt agreements. Second, it is not good
business for a firm to deal unfairly with its creditors. Unethical behavior
has no place in business, and if creditors perceive that a firm’s
managers are trying to take advantage of them, they will either refuse to
deal further with the firm or will charge higher interest rates to compensate
for the risk of possible exploitation. High interest rates and/or the loss of
access to capital markets are detrimental to shareholders. In view of all this, it
follows that to best serve their shareholders in the long run;managers should
play fairly with creditors. Similarly, because of other constraintsand
sanctions, management actions that would expropriate wealth from any
of the firm’s other stakeholders, including its employees, customers,
suppliers, and community, will ultimately be to the detriment of its
shareholders. In our society, long-run stock price maximization requires fair
treatment for all parties whose economic positions are affected by
managerial decisions.