Presentation on theme: "AGENCY THEORY.

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1  AGENCY THEORY

2  IntroductionAgency theory provides the framework for discussing the relationships that exist
between the various interest groups in an organization.It views the firm as a “composite unit”
consisting of separate interest groups.Each interest group pursues its own interest and ensures it
stands at an advantageous position in relation to the firm.Each individual group however recognizes
the fact that its success is a function of the company vis-à-vis other companies in the same industry.

3  Agency theoryThe theory brings out a clear exposition of the actions of some managers which are
not in consonance with the actions they were to take, assuming shareholder’s wealth maximization
objective is pursued.

4  Agency RelationshipAgency relationship exists when one person (or a group of persons) called
the Principal, appoints another person called the Agent to perform some work on its behalf and gives
the agent the appropriate decision-making authority.In the context of Strategic Financial
Management, such relationships occur, among others between:Shareholder’s and managers;
andCreditors and shareholders

5  Agency RelationshipIt is natural that where such relationship exists, there is bound to be conflict
of interest which creates a problem known as agency problem.The reason underlining the conflict in
the case of shareholders-managers relationship is the separation of ownership and control.

6  Shareholders vs Managers
The reason underlining the conflict is the separation of ownership and control. This may arise in the
following situations:Choice of Projects Appraisal TechniqueIn pursuit of their self-interests,
managers may prefer projects with short lives against those with long lives. They may therefore want
to use Payback technique instead of the superior Net Present Value technique.

7  Shareholders vs Managers
Appraisal of Risky ProjectsFinancial managers may not want to undertake projects which bring
substantial benefits to the owners, but are highly risky, because of the negative impact of this risk on
their own financial position. However, this risk has presumably been well diversified away by the
shareholders.

8  Shareholders vs Managers
GearingFinancial managers may not want the company’s debt to be unduly large in relation to
equities so as to reduce the financial risk of the company. Financial managers may however, by
doing this, not be taking advantage of tax-deductible interest cost, where interest is treated by the
tax authorities as a charge against profits.

9  Shareholders vs Managers
Takeover bidsWhen a company is compulsorily taking over another company, the target company’s
directors may be resisting such action in order to protect their own jobs; even though it will bring
greater wealth to the existing shareholders.
10  Shareholders vs Managers
Leveraged Buy-OutIn a leveraged buy-out, the company’s management borrows funds to purchase
the outstanding shares of the company via a tender offer (an offer to buy the shares of a company
directly from the shareholders). There is the possibility that managers might try to drive down the
price of the company’s share just before the tender offer, so that they can buy the shares at a
bargain price.

11  Shareholders vs Managers
Dividend PolicyThis is where financial managers are pursuing an unduly conservative dividend
policy: that is, trying to keep dividends at a level which is much lower than the normal level, given the
industry norms. The question , however, is: can the funds not distributed be utilized better by the
shareholders themselves, if received as dividends?

12  Shareholders vs Managers
Disclosure of Information in the Financial StatementsThis is where financial managers “paint” the
financial condition of the company via its balance sheet , rosier than what it really is. This is known
as “window dressing” or, in a mild form, “creative accounting”. It is made possible by the open-ended
nature of the choice of accounting policies, when directors prepare financial statements. For
example, directors might want to defer certain type of expenditure (e.g. advertising) and capitalize it
or put value on intangibles such as patents.

13  Shareholders vs Managers
EthicsTop management might display certain unethical practices when it makes some decisions on
operations. Typical examples of such practices are the degradation of the environment through
pollution and testing of products on human beings.

14  Shareholders vs. Managers

Possible solutionsShareholders need to ensure that there is “Goal congruence”.Goal congruence
means convergence of the interests of different groups such that the overall goal of the company
can be achieved.It means the need for shareholders to ensure that managers take actions in
accordance with their expectations and in their best interest.

15  Shareholders vs. Managers

Possible solutionsThe actions necessary to achieve goal congruence are as follows:MonitoringThe
company needs to monitor every action of management. However, some costs known as agency
costs would be incurred. This is an expensive way of ensuring goal congruence. Agency costs would
include expenditure that is necessary to physically monitor the manager and expenditure to
restructure the organization so that bad elements within the system are removed.

16  Shareholders vs. Managers

Possible solutionsThe actions necessary to achieve goal congruence are as follows:MonitoringThey
also include opportunity costs arising from profits lost when managers take decisions as agents
instead of as owner-managers; decision-making is slow in the former but fast in the latter.

17  Shareholders vs. Managers

Possible solutionsThe actions necessary to achieve goal congruence are as follows:Compensation
via allocation of shares in the companyIn this case costs might not be too prohibitive as managers
would gear their efforts toward profitability and capital appreciation via cutting down operational
costs including salaries and fringe benefits and taking less time off duty.
18  Shareholders vs. Managers
Possible solutionsIn between Monitoring and Compensation via allocation of shares in the company
are the following :Threat to DismissalThis may not be effective as ownership in many big companies
(where ownership and control are highly separated) is widely dispersed and shareholders often find
it difficult to speak with one voice. Few shareholders attend the annual general meetings and, in any
case, directors usually ensure they get enough proxies to support them at meetings. It should be
noted however, that the presence of institutional investors could weaken the directors strength.

19  Shareholders vs. Managers

Possible solutionsIn between Monitoring and Compensation via allocation of shares in the company
are the following :Exposure to Take-over BidThis could deter managers from taking actions that will
be at variance with share price maximization. If the company’s earning potentials are being
knowingly or unknowingly suppressed through bad policies and the share is consequently
undervalued, in relation to its value, it may be exposed to hostile-take-over bid. The result is that
some top managers might lose their jobs and the authorities of those remaining might be drastically
reduced.

20  Shareholders vs. Managers

Possible solutionsIn between Monitoring and Compensation via allocation of shares in the company
are the following :Executive Share Option SchemeThis is a performance-based scheme that allows
top managers to buy the shares of the company in future, at a price determined now. The belief is
that this will motivate the managers to continually take actions that will be pushing up the share
price: the option has value if the price of the share increases above the originally fixed option
purchase price. It should be noted, however that this scheme may not be beneficial to managers in a
period of market downturn.

21  Shareholders vs. Managers

Possible solutionsIn between Monitoring and Compensation via allocation of shares in the company
are the following :Performance SharesThese are shares given to top managers and linked to
company’s performance as mirrored by its fundamentals – earnings per share, return on capital
employed, return on equity, dividend per share and so on. This scheme is valuable to the extent that
it is not affected by vagaries of the stock market.Vagaries - an unexpected and inexplicable change
in a situation or in someone's behavior.Synonyms: change, fluctuation, variation, quirk, peculiarity,
oddity,

22  Creditors vs. Shareholders

The agency problem of creditors and shareholders (with managers as agents) arises from two
situations:Capital InvestmentsCreditors would not like a situation where the acceptance of a project
will add greater business risk than is expected by them. If this happens, they will increase their
required rate of return and the value of their outstanding debt will fall. The major concern of creditors
here is that if risky project succeeds, creditors will only receive a fixed amount (interest income) and
shareholders will take all the benefits’ whereas, if the project fails, they will share the losses with the
owners.

23  Creditors vs. Shareholders

The agency problem of creditors and shareholders (with managers as agents) arises from two
situations:GearingWhere the company increases its gearing (debt/equity) ratio to a level that
increases financial risk to more than expected, the value of the existing debt will fall because the
earnings and assets backing available for this debt will diminish as a result of the new issue of debt.
24  Creditors vs. Shareholders
In – built SolutionShareholders do try as much as possible not to exploit creditors as such action
may attract punitive high interest rates, restrictive covenants, restricted access to capital market, all
of which may result in a fall in the long-term value of the company’s share. Shareholders would,
therefore, want to continue to maintain good and cordial relationship with their creditors, as it is by
doing so, that their wealth will be maximized.