Agency Theory

Agency theory is a principle that is used to explain and resolve issues in the relationship
between business principals and their agents. Most commonly, that relationship is the one
between shareholders, as principals, and company executives, as agents.

An agency, in broad terms, is any relationship between two parties in which one, the
agent, represents the other, the principal, in day-to-day transactions. The principal or
principals have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect
the principal financially are made by the agent, differences of opinion and even differences in
priorities and interests can arise. This is sometimes referred to as the principal-agent
problem.

By definition, an agent is using the resources of a principal. The principal has entrusted
money but has little or no day-to-day input. The agent is the decision-maker but is incurring
little or no risk because any losses will be borne by the principal.

Agency Conflict
1. If a manager is a partial owner of the firm, he may make decisions that are not
aligned with goal of maximizing shareholder wealth.
2. Managers, acting in the interest of shareholders, may take on projects with
greater risk than creditors anticipated and raise the debt level higher than
expected.
Agency Cost
1. Managers may work less eagerly and benefit themselves in terms of salary and perks.
2. Managers may reduce share capital price.
3. Control measures employed to regulate undesirable management actions calls for
higher agency cost
Control Mechanism
1. Severance of contract
2. Provide performance-based incentive plans or stock option plans are given to
managers.
3. Involvement by shareholders (institutional) - if he owns a reasonable share in the
firm, he can sponsor a proposal which must be voted at the annual stockholders
meeting, regardless of management's approval.
4. Shareholders in some cases do hostile takeovers.