1.

AGENCY THEORY AND RELATIONSHIPS

Agency theory is concerned with agency conflicts, or conflicts of interest between agents and
principals. This has implications for, among other things, corporate governance and business
ethics. When agency occurs, it also tends to give rise to agency costs, which are expenses incurred
in order to sustain an effective agency relationship. Accordingly, agency theory has emerged as a
dominant model in the financial economics literature, and is widely discussed in business ethics
texts. An agency relationship arises whenever one or more individuals, called principals, hire one
or more other individuals, called agents, to perform some service and then delegate decision-
making authority to the agents. The primary agency relationships in business are
• Between stockholders and managers
• Between debt holders and stockholders
Stockholder-Manager Conflicts:
Shareholders invest their money in a company by purchasing the shares. There is separation of
ownership as companies have separate legal entity feature. They normally employ a management
team to help run the operations of the firm. Managers are typically employed through a contract
which specifies remuneration and responsibilities, but they do not personally bear the entire
financial consequences of decisions made. The shareholders may not be able to manage the firm
because:
• They may not have necessary skills to manage the firm
• They may be too many to manage one firm
• They may be geographically dispersed to converge in one location
Conflict of interest usually occurs between managers and shareholders in the following ways:
- Managers may not work hard to maximize shareholders wealth if they perceive that
they will not share in the benefit of their labor.
- Consumption of perks Managers may award themselves huge salaries and other
benefits more than what a shareholder would consider reasonable. The managers may
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.
- Managers may maximize leisure time at the expense of working hard.
 - Manager may undertake projects with different risks than what shareholders would
consider reasonable.
- Manager may undertake projects that improve their image at the expense of
profitability.
- Where management buyout is threatened. ‘Management buyout’ occurs where
management of companies buy the shares not owned by them and therefore make the
company a private one.

Solutions to this Conflict

• Incurring Agency costs
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. Michael Jensen
and William Meckling suggested that corporate debt levels and management equity levels
are both influenced by a wish to contain agency costs. There are three major types of
agency costs:
- Monitoring costs: Expenditures to monitor managerial activities, such as audit
costs;
- Restructuring costs: Expenditures to structure the organization in a way that will
limit undesirable managerial behavior, such as appointing outside members to the
board of directors or restructuring the company's business units and management
hierarchy; and
- Opportunity costs: 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.
• Performance-based incentive plans:
The Shareholder may offer the management profit-based remuneration. This remuneration
includes:
- An offer of shares so that managers become owners
- Share options: (Option to buy shares at a fixed price at a future date).
- Profit-based salaries e.g. bonus
 • Threat of firing:
Shareholders have the power to appoint and dismiss managers which is exercised at every
Annual General Meeting (AGM). The threat of firing therefore motivates managers to
make good decisions.
• Threat of Takeover:
If managers do not make good decisions then the value of the company would decrease
making it easier to be acquired especially if the predator (acquiring) company beliefs that
the firm can be turned round.

Stockholder-Creditor Conflicts:
Shareholders control all decisions of the firm. If a firm invests in high risk projects the return may
be high too yet the debt holders will earn a fixed interest income thus the shareholders will hugely
benefit from this to the detriment of the creditors. If the projects fail the creditors are also likely to
lose their money. Therefore creditors will place restrictive covenants on lending agreements
which, in turn, may be seen by equity owners as wealth reducing since it limits the ability to take
risks. This problem arises because of potential conflict between stockholders and creditors.
Creditors lend funds to the firm at rates that are based on:
- Riskiness of the firm's existing assets
- Expectations concerning the riskiness of future assets additions
- The firm's existing capital structure
- Expectations concerning future capital structure changes.
These are the factors that determine the riskiness of the firm's cash flows and hence the safety of
its debt issue.
Creditors will protect themselves against the above problems through:
Restrictive covenants.
These covenants may restrict:
• The company’s asset base
• The company’s ability to acquire additional debts
• The company’s ability to pay future dividend and management remuneration
• The management ability to make future decision (control related covenants)
If creditors perceive that shareholders are trying to take advantage of them in unethical ways, they
will either refuse to deal further with the firm or else will require a much higher than normal rate
of interest to compensate for the risks of such possible exploitations.
It therefore follows that shareholders wealth maximization require fair play with creditors. This
is because shareholders wealth depends on continued access to capital markets which depends on
fair play by shareholders as far as creditor's interests are concerned.