Agency Problem ( Cost ) 1

FIN301 Managerial Finance – Honors Program

Instructor: Dr. Mustafa Dah

Final Project

Topic: Agency Problem ( Cost )

By Celine Dagher

& Cynthia Melhem

Agency Problem ( Cost ) 2

Outline

A. Introduction ........................................................................................................................ 3

B. Forms of business organization .......................................................................................... 4

a) Sole proprietorship

b) Partnership

c) Corporation

C. Agency relationship............................................................................................................. 5

D. Agency problem................................................................................................................... 6

E. Incentives to reduce agency problem....................................................................................8

a) Law

b) Auditors

c) Supervision and monitoring of management performance

d) Compensation

F. Agency cost........................................................................................................................10

G. Conclusion..........................................................................................................................13
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A. Introduction

The recent dramatic increase in corporate scandals and firms' value destruction are arising

mainly from the divergence of interests in managing corporations. The agency view of the

corporation implies that the decision-making authority in corporations is delegated to managers

to act in shareholders' interests. Moral hazard and conflict of interests may arise due to the

different interests and information that the two parties have. The principal cannot directly ensure

that the agents are always acting in the principals' best interests, particularly when activities that

are useful to principals are omitted by agents, and where elements of what agents do are costly

for principals to monitor. Partly as a result of this separation, corporate governance mechanisms

include a system of controls intended to help align managers' incentives with those of

shareholders and other stakeholders. Agency problem arises whenever the welfare of one party,

termed the ‘principal’, depends upon actions taken by another party, the 'agent'. The greater the

complexity of the tasks undertaken by the agent, and the greater the discretion the agent must be

given, the larger these agency costs are likely to be. This paper deals with the different

principal-agent relationships and problems present in corporations, incentives to minimize them

as well as the costs generated from the deviation of interests.

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B. Forms of business organization

A business can be structured in several forms, and the way its owners decide will influence

the company's and owners' legal liability and income tax treatment. Sole proprietorship,

partnership and corporation are the three types of business organization.

Business Forms

Sole
Partnerships
Proprietorships Corporations

a) Sole proprietorship

Sole proprietorship is a business owned by a single person who is entitled to all of the firm’s

assets as well as its profits and is responsible for all of the firm’s debt. No distinction exists

between the owner and the business when it comes to being sued or debts. Sole proprietorship is

financed by personal and business loans from banks.

b) Partnership

Partnership can be classified in two forms: general partnership and limited partnership. General

partnership consists of two or more individuals who co-own the business and face unlimited

liability for the firm's debts while limited partners are only responsible for the amount they

invested.
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c) Corporation

The corporate structure separates the owner from the business entity. It is legally owned by its

current shareholders and can sue, be sued, own or sell property and purchase assets. Stockholders

elect the Board of Directors who in turn elect the managers.

C. Agency relationship
Agency relationship is defined as a contract under which one or more persons (the

principal(s)) engage another person (the agent) to perform some service on their behalf which

involves delegating some decision making authority to the agent. In a corporation, an agency

relationship exists between corporate ‘insiders,’ such as top managers and controlling

shareholders, and ‘outsiders,’ such as minority creditors or shareholders. Three types of agency

relationship arise in business firms:

 The firm’s owners (principals) and its hired managers (agents)

 The minority or non-controlling owners (principals) and the controlling owners (agents)

 The parties with whom the firm contracts ( principals) and the firm itself (agent)

Agents do not always work in the principals' best interests, leading therefore to agency problems

with significant costs.

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D. Agency Problem

Agency problem, also commonly called " principal-agent problem", lies in the conflict of

interest that arises when the agent acts in its own interest rather than the managers' interest.

Viewed in these terms, agency problems arise in a broad range of contexts. In particular, almost

any contractual relationship, in which one party (the ‘agent’) promises performance to another

(the ‘principal’), is potentially subject to an agency problem. The core of the difficulty is that,

because the agent usually has more information than the principal about the relevant facts, the

latter cannot easily assure himself that the agent’s performance is precisely what was promised.

As a consequence, the agent has an incentive to act opportunistically, skimping on the quality of

his performance, or even diverting to himself some of what was promised to the principal. This

means, in turn, that the value of the agent’s performance to the principal will be reduced, either

directly or because, to assure the quality of the agent’s performance, the principal must engage in

costly monitoring of the agent.

It is worthwhile to point out the generality of the agency problem. The problem of inducing

an agent to behave as if he were maximizing the principal’s welfare is quite general. It exists in

all organizations and in all cooperative efforts—at every level of management in firms, in

universities, in mutual companies’ governmental authorities and bureaus, in unions, and in

relationships normally classified as agency relationships such as those common in the

performing arts and the market for real estate.

Three generic agency problems arise in business firms.:

a. The first one involves the conflict between the firm’s owners and its hired managers.

Here, the owners are the principals and the managers are the agents. The problem lies in
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assuring that the managers are responsive to the owners’ interests rather than pursuing

their own personal interests. Managerial goals may be different from shareholder goals.

Agents tend to :

 Spend fund on expensive perquisites (example: buying a luxurious corporate jet)

 Managers might not take an investment because it is relatively risky, although it is

expected to increase the share value in order to ensure the survival of the firm

 Increased growth and size are not necessarily equivalent to increased shareholder wealth.

Management, for example, may overpay to buy up another company just to increase the

size of the business or to demonstrate corporate power. This does not benefit

shareholders.

 Managers might try to maximize the amount of resources over which they have control

and power . This leads to an overemphasis on corporate size and growth.

b. The second agency problem involves the conflict between, on one hand, owners who

possess the majority or controlling interest in the firm and, on the other hand, the

minority or non-controlling owners. The non-controlling owners can be thought of as the

principals and the controlling owners as the agents, and the difficulty lies in assuring that

the former are not expropriated by the latter. While this problem is most prominent

between majority and minority shareholders, it appears whenever some subset of a firm’s

owners can control decisions affecting the class of owners as a whole. Thus, if minority

shareholders enjoy veto rights in relation to particular decisions, it can give rise to a

species of this second agency problem. Similar problems can arise between ordinary and
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preference shareholders, and between senior and junior creditors in bankruptcy (when

creditors are the effective owners of the firm).

c. The third agency problem involves the conflict between the firm itself—including,

particularly, its owners—and the other parties with whom the firm contracts, such as

creditors, employees, and customers. In this case, the difficulty lies in assuring that the

firm, as agent, does not behave opportunistically toward these various other principals—

such as by expropriating creditors, exploiting workers, or misleading consumers.

In each of the foregoing problems, the challenge of assuring agents’ responsiveness is greater

where there are multiple principals and especially so when they have different interests, or

‘heterogeneous preferences’ as economists say.

E. Incentives to reduce agency problem

The principal can limit divergences from his interest by establishing appropriate incentives for

the agent designed to limit his deviant activities.

a) Law

Law can play an important role in reducing agency problems. Obvious examples are rules and

procedures that enhance disclosure by agents or facilitate enforcement actions brought by

principals against dishonest or negligent agents.

b) Auditors

External auditors will not only be able to play vital roles in corporate and financial reporting,

hence reducing information asymmetries which may exist between principal and agent, but will

also be supported through internal monitoring devices as audit committees. Audit committees not
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only help to minimize financial, operational and compliance risks, but also enhance the quality of

financial reporting. As well as playing a fundamental role in transmitting financial results to the

general public, the audit committee serves as representative of shareholder interests and is

required to facilitate a process whereby management and the chief executive can be questioned

and held to account. The audit committee is not only responsible for monitoring the financial

reporting process, but also the effectiveness of the company’s internal controls, the internal audit

and risk management systems. It is also assigned with the task of monitoring the statutory audit

of the annual and consolidated accounts.

c) Supervision and monitoring of management performance

The level of monitoring undertaken by an agent, on behalf of its principal, is a primary

determinant of the level of performance which can be attained by a firm. It is frequently

contended that less dispersed ownership generally results in greater monitoring on the part of the

agents or management of the firm. Concentrated ownership not only brings more effective

monitoring of management, but also aids in overcoming the agency problems arising from the

separation of ownership and control, even though they admit that certain costs, namely, that of

low liquidity and reduced possibilities for risk diversification, exist.

d) Compensation

Compensation is necessary in motivating agents or executives, but incentives should be aimed at

generating improved long term performance and results rather than a focus on short term

performance and results. Therefore, rewards should be tied to those schemes which would

encourage greater focus on long term results. Such incentives would also discourage unnecessary
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behaviors which results in high risk taking levels. Remuneration packages and compensation for

executives should be dependent on their ability to comply with capital and liquidity

requirements. In rewarding executives for compliance with capital and liquidity requirements,

such compensation will not only help secure the profitability and performance of such complying

firms, but will also help to avoid systemic contagion which could arise as a result of liquidity and

systemic risks.

F. Agency Cost

It is generally impossible for the principal or the agent at zero cost to ensure that the agent

will make optimal decisions from the principal’s point of view. In general, reducing agency costs

is in the interests of all parties to a transaction, principals and agents alike.

Rules of law that protect creditors from opportunistic behavior on the part of corporations

should reduce the interest rate that corporations must pay for credit, thus benefiting corporations

as well as creditors. Likewise, legal constraints on the ability of controlling. Paradoxically,

mechanisms that impose constraints on agents’ ability to exploit their principals tend to benefit

agents as much as, or even more than hey benefit the principals. The reason is that a principal

will be willing to offer greater compensation to an agent when the principal is assured of

performance that is honest and of high quality.

In most agency relationships, the principal and the agent will incur positive monitoring and

bonding costs (non-pecuniary as well as pecuniary), and in addition there will be some

divergence between the agent’s decisions and those decisions which would maximize the welfare

of the principal. The dollar equivalent of the reduction in welfare experienced by the principal as

a result of this divergence is also a cost of the agency relationship, and we refer to this latter cost
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as the “residual loss.” Agency cost is defined as the sum of the monitoring expenditures by the

principal, the bonding expenditures by the agent and the residual loss.

1. The monitoring expenditures by the principal

Monitoring costs are incurred when the principals attempt to monitor or restrict the actions of

agents. For example, the board of directors at a company acts on behalf of shareholders to

monitor and restrict the activities of management to ensure behavior that maximizes shareholder

value. The cost of having a board of directors is therefore, at least to some extent, considered an

agency monitoring cost. Costs associated with issuing financial statements and employee stock

options are also monitoring costs.

2. The bonding expenditures by the agent

Bonding costs are incurred by the agent in order to guarantee that he will not take certain actions

which would harm the principal or to ensure that the principal will be compensated if he does

take such actions. An agent may commit to contractual obligations that limit or restrict the

agent’s activity. For example, a manager may agree to stay with a company even if the company

is acquired. The manager must forego other potential employment opportunities. In some

situations principal will pay the agents to expend resources (bonding costs) to guarantee that they

will not take certain actions which would harm the principal or to ensure that the principal will

be compensated if they do take such actions.

3. The residual loss

Residual losses are the costs incurred from the divergences between the agent's actual decisions

and the decisions that would maximize the welfare of the principal. There will be some
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divergence between the agent’s decisions and those decisions which would maximize the welfare

of the principal. Residual loss is not measured relative to the principal’s expectations, nor is it

measured relative to a perfect performance by an ideal agent.

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G. Conclusion

The publicly held business corporation is an important social invention. Millions of

individuals voluntarily entrust billions of dollars, francs, pesos and other types of personal

wealth to the care of managers on the basis of a complex set of contracting relationships which

delineate the rights of the parties involved. The growth in the use of the corporate form as well as

the growth in market value of established corporations suggests that at least, up to the present,

creditors and investors have by and large not been disappointed with the results, despite the

agency costs inherent in the corporate form.

Agency costs are as real as any other costs. The level of agency costs depends, among other

things, on statutory and common law and human ingenuity in devising contracts. Both the law

and the sophistication of contracts relevant to the modern corporation are the products of a

historical process in which there were strong incentives for individuals to minimize agency costs.

Moreover, there were alternative organizational forms available, and opportunities to invent new

ones. Whatever its shortcomings, the corporation has thus far survived the market test against

potential alternatives.
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References

Amour, J., Hansmann, H. & Kraakman, R. ( 2009 ). Agency Problems, Legal Strategies and

Enforcement. ECGI. Retrieved from

www.ecgi.org/wp

Hansmann, H. & Kraakman, R. ( 2004 ). Agency Problems and Legal Strategies. The Anatomy

of Corporate Law, pp. 21-22

Jensen, M. & Meckling, W. ( 1976 ). Theory of the Firm: Managerial Behavior,

Agency Costs and Ownership Structure. Journal of Financial Economics,

pp. 305-360