What Is Agency Theory ?

Agency theory is the branch of financial economics that looks at

conflicts of interest between people with different interests in the
same assets.

This most importantly means the conflicts between:

shareholders and managers of companies
shareholders and bond holders.
The theory explains the relationship between principals, such as a
shareholders, and agents, such as a company's managers.
In this relationship the principal delegates (or hires) an agent to
perform work.

The theory attempts to deal with two specific problems:

how to align the goals of the principal so that they are not in conflict
(agency problem), and
that the principal and agent reconcile different tolerances for risk.

Origins Of agency Theory ?

During the 1960s & 1970s , economists explored risk sharing among
individuals or groups. This literature described the risk sharing
problem as one that arises when co-operating parties have different
attitudes toward risks.
Agency Theory broadened this risk sharing literature to include the
so called agency problem that occurs when co-operating parties
have different goals and division of labour.
Specifically, this theory is directed at the ubiquitous agency
relationship ,in which one party delegates work to another agent
who performs that work. Agency Theory attempts to describe this
relation using the metaphor of a contract. Agency Theory suggests
that the firm can be viewed as a nexus of contracts (loosely defined)
between resource holders.

CONFLICTS BETWEEN MANAGERS AND

SHAREHOLDERS
Why conflict of interest between shareholders and
management?
To address the conflict of interest between shareholders and
management, it is important to stress that even within the same
class of shareholders, there may be conflicts, this conflict may
relate to what proportion of the companys profit should be paid in
the form of dividend and what proportion should be retained for
future investments and for capital investment purposes.
Other potential conflicts may involve companys ethical policies, its
corporate and social responsibilities policies.
The agency theory, considering the potential conflicts of interest
between shareholders and management may arise as a result of
several factors, some of such factors include:
Reward to management
Risk attitudes of management and shareholders
Takeover decisions by management
Time horizon of management

SELF-INTERESTED BEHAVIOR

Agency theory suggests that, in imperfect labor and capital markets,

managers will seek to maximize their own utility at the expense of
corporate shareholders.
Agents have the ability to operate in their own self-interest rather
than in the best interests of the firm because of asymmetric
information (e.g., managers know better than shareholders whether
they are capable of meeting the shareholders' objectives) and
uncertainty (e.g., myriad factors contribute to final outcomes, and it
may not be evident whether the agent directly caused a given
outcome, positive or negative).
Evidence of self-interested managerial behaviour includes the
consumption of some corporate resources in the form of perquisites
and the avoidance of optimal risk positions, whereby risk-averse
managers bypass profitable opportunities in which the firm's
shareholders would prefer they invest. Outside investors recognize
that the firm will make decisions contrary to their best interests.
Accordingly, investors will discount the prices they are willing to pay
for the firm's securities.

The interest of shareholders may include:

Increasing earning per share (EPS), and current share prices

Increasing investor ratios such as dividend per share (DPS), dividend
cover, dividend yield, price-earning (P/E) ratio
Others may include the company improving its corporate and social
responsibilities

Management interest may include:

Managing the firm to achieve its objectives

Increasing the wealth and size of the company, by expanding
the companys activities, the bigger the size of the company
they manage the better they are perceived to be.
Increasing their personal wealth by paying themselves high
remunerations and other benefits

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT

Agency costs are defined as those costs borne by shareholders to
encourage managers to maximize shareholder wealth rather than
behave in their own self-interests.
There are three major types of agency costs:
(1) expenditures to monitor managerial activities, such as audit
costs;
(2) expenditures to structure the organization in a way that will limit
undesirable managerial behaviour, such as appointing outside
members to the board of directors or restructuring the company's
business units and management hierarchy; and
(3) opportunity costs which are incurred when shareholder-imposed
restrictions, such as requirements for shareholder votes on specific
issues, limit the ability of managers to take actions that advance
shareholder wealth.

MECHANISMS FOR DEALING WITH SHAREHOLDERMANAGER CONFLICTS

There are two polar positions for dealing with shareholder-manager agency
conflicts.
At one extreme, the firm's managers are compensated entirely on the basis
of stock price changes. In this case, agency costs will be low because
managers have great incentives to maximize shareholder wealth. It would be
extremely difficult, however, to hire talented managers under these
contractual terms because the firm's earnings would be affected by
economic events that are not under managerial control.
At the other extreme, stockholders could monitor every managerial action,
but this would be extremely costly and inefficient.

(1)
(2)
(3)
(4)

The optimal solution lies between the extremes, where executive

compensation is tied to performance, but some monitoring is also
undertaken. In addition to monitoring, the following mechanisms encourage
managers to act in shareholders' interests:
performance-based incentive plans,
direct intervention by shareholders,
the threat of firing, and
the threat of takeover.

STOCKHOLDERS VERSUS CREDITORS: A SECOND

AGENCY CONFLICT
In addition to the agency conflict between stockholders and
managers, there is a second class of agency conflict between
creditors and stockholders.
Creditors have the primary claim on part of the firm's earnings in the
form of interest and principal payments on thedebtas well as a
claim on the firm's assets in the event of bankruptcy.
The stockholders, however, maintain control of the operating
decisions (through the firm's managers) that affect the firm's cash
flows and their corresponding risks.
Shareholder-creditor agency conflicts can result in situations in
which a firm's total value declines but its stock price rises. This
occurs if the value of the firm's outstanding debt falls by more than
the increase in the value of the firm's common stock.

AGENCY VERSUS CONTRACT

Although the notions of agency and contract are closely intertwined,

some academics bristle at the suggestion they are essentially the
same.
A conventional view holds that agency is a special application of
contract theory. However, some argue that the reverse is true: a
contract is a formalized, structured, and limited version of agency,
but agency itself is not based on contracts

AGENCY AND ETHICS

Since agency relationships are usually more complex and
ambiguous (in terms of what specifically the agent is required to
do for the principal) than contractual relationships, agency carries
with it special ethical issues and problems, concerning both
agents and principals.
Ethicists point out that the classical version of agency theory
assumes that agents (i.e., managers) should always act in
principals' (owners') interests.
However, if taken literally, this entails a further assumption that
either:
(a)
(b)

the principals' interests are always morally acceptable ones or

managers should act unethically in order to fulfill their "contract"
in the agency relationship.
Clearly, these stances do not conform to any practicable model of
business ethics.

Key idea

Principal-agent relationships should reflect efficient organization of information

and risk-bearing costs

Unit of
analysis

Contract between principal and agent

Human
assumptions

Self-interest Bounded rationality Risk aversion

Organizational
assumptions

Partial goal conflict among participants Efficiency as the effectiveness criterion

Information asymmetry between principal and agent

Information
assumption

Information as a purchasable commodity

Contracting
problems

Agency (moral hazard and adverse selection) Risk sharing

Problem
domain

Relationships in which the principal and agent have partly differing goals and risk
preferences (e.g., compensation, regulation, leadership, impression management,
whistle-blowing, vertical integration, transfer pricing)

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