agency problem, types of the agency problem, and how to control it
Do you have concerning agency problem or perhaps you have some of the questions below in mind;
- What is the agency problem?
- What is an example of an agency problem?
- What is agency problem and what are the methods to control it?
- What are the different types of agency problems?
If so then all your questions regarding the agency problem are going to be solved in this article or guide.
You are welcome to our new article on agency problem. In this session, we shall discuss the agency problem and how it can be resolved. The causes of agency problems will also be explained in this session.
AGENCY PROBLEM, TYPES OF AGENCY PROBLEM, AND HOW TO CONTROL IT
At the end of this session, we expect that you are geared for the course in business finance at your workplace or everywhere you want to apply it.
Objectives by the end of this session, you should be able to:
(a) explain agency theory
(b) describe the agency problem
(c) identify the causes of agency problem
(d) suggest ways of solving agency problem in organizations
Now read on …
6.1 AGENCY THEORY
One area of continuing financial research has been agency theory. This theory examines the relationship between the owners and the managers of the business.
An agency relationship arises whenever one or more individuals, called principal(s);
- Hires another individual or organization, called an agent, to perform some service and
- Then delegates decision-making authority to that agent. In a business finance context, the primary agency relationships are those between shareholders and managers, and managers and debt-holders.
6.2 WHAT IS AGENCY PROBLEM?, MEANING OF AGENCY PROBLEM
In privately-owned businesses, management and owners are usually the same people.
Management operates the business to satisfy its own goals, needs, and financial requirements. However, as a company moves from private to public ownership, management now represents all the owners.
Read also: Meaning of business finance
This places management in the agency’s position of making decisions that will be in the best interest of all shareholders. Because of diversified ownership interests, conflict between managers and shareholders can arise that will impact the financial decisions of the business.
Such conflicts are called agency problems.
6.3 FORCES THAT GIVE RISE TO AGENCY PROBLEM
The forces that give rise to agency problem between management and shareholders include:
- Separation of ownership from control: Those who own the company do not manage it.
- Information symmetry: A situation where management has a clear advantage of hiding financial and non-financial reports from owners. Management therefore knows it all while shareholders know only what the managers wish them to know.
- The goals of managers may differ from those of owners. For instance, management may;
- seek to entrench managerial power by creating job security for themselves
- increase managerial rewards and enhancements
- pursue their own social objectives, such as traveling ostentatiously with their family and undertaking prestigious projects.
6.4 HOW AGENCY PROBLEM ARISES
Agency problem can also exist between management and debt-holders/creditors when management takes decisions which adversely affect the safety of creditors’ debts such as:
(i) Approving excessive dividends, the payment of which may pose danger to future payments of interest and principal.
(ii) Going for more debt without considering the implications on existing debt-holders.
(iii)Undertaking highly risky business ventures.
Suppose you hire someone to sell your car and you agreed to compensate him a flat fee when the car is bought.
The agent’s incentive, in this case, is to make the sale, not necessarily to get you the best price. If you paid a commission of say 5% of the sales price instead of a flat fee, then this problem might not exist.
In much the same way, just as managers are not the owners of the business, they might be tempted to act in ways that are not in the best interest of the owners. For example, they might buy luxury corporate cars for their travel, or overindulge in expense-account dinners.
They might shy away from attractive but risky projects because they are worried about the safety of their jobs than the potential for superior profits. They might be engaged in empire building, adding unnecessary or hire employees.
Such problems can arise because the managers of the firm may have their own axes to grind.
6.5 AGENCY COSTS
to reduce agency problems and associated moral hazard problems created by management actions, stockholders must incur agency costs. The three (3) major categories of agency costs include:
- expenditure to monitor managerial actions such as audit costs
- expenditures to structure the firm in a way that will limit undesirable managerial behavior such as appointing outside investors to the board of directors, and
- opportunity costs that are incurred when shareholders impose restrictions.
6.6 WAYS OF RESOLVING AGENCY PROBLEMS
What is agency problem and what are the methods to control it?
Agency problem between shareholders and managers can be resolved as follows:
- Tying managerial compensation to the financial performance of the firm in general, or to the performance of the share value on the stock market in particular. Managerial compensation may take the form of remuneration increases, promotion, etc.
- Direct intervention by shareholders to influence the decisions of management through:
- Talking with the firm’s management and making suggestions regarding how the business should be run, i.e. lobbying
- The proposal made by a majority shareholder(s) to be voted on at the AGM, even if it is opposed by management.
(iii)Threat of firing management if they are not acting in stockholders’ interest.
(iv) Threat of takeovers, particularly hostile takeovers (a takeover usually opposed by management) which occurs when the firm’s stocks have been undervalued relatively due to poor management.
- In the same vein, the agency problem between management and creditors can be resolved by debt-holders as follows;
- Debt-holders can protect their interest by securing debt against the company’s assets.
- Use of restrictive covenants to restrict the firm from engaging in highly risky ventures, from paying excessive dividends, and from engaging in high levels of gearing.
Finally, we have ended this session and the unit. We learned agency theory and the agency problem. We examined the causes of agency problems and ways of resolving them. We also looked at the costs associated with agency problem.
By: Eric Adjei
A professional with six (7) years’ experience in finance and accounting. Demonstrating expertise in accounting procedures, computerized accounting system management and financial operations. Financially astute with excellent analytical, problem solving, management, people supervision, organizational, business administration, operation and commercial management and teaching skills.