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 labor.
Specifically, this theory is directed at the omnipresent 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

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 SHAREHOLDER-MANAGER

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.
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

shareholders' interests:
(1)

performance-based incentive plans,

(2)

direct intervention by shareholders,

(3)

the threat of firing, and

(4)

the threat of takeover.

encourage

managers

to

act

in

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 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)

the principals' interests are always morally acceptable ones or

(b)

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, whistleblowing, vertical integration, transfer pricing)

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