Dire Dawa University

College of Business and Economics

Department of Management

MBA program

Individual Assignment for the course Financial Management (MBA721)

By: Ephrem Belete (DDU1500451)

Weekend Program

December, 2023
Agency Problem and Agency Cost

I) Agency Problem

According to Jerzemowska (2006), according to perceived wisdom, the main aim of a company
is to maximize its stock market value. Managers of the company are responsible for achieving
that aim, i.e. for maximizing shareholders’ wealth. The performance that a company achieves
reveals how successful the management is in adapting to changing circumstances. The ability to
quickly and properly react to changes in the business environment characterizes the quality of
the company’s management.

According to the theory of the relationship between principals (owners) and agents (managers),
principal-agent theory (Gauld, 2016), owners hires managers to run the firm on their behalf.
The theory studies the interaction between an agent and the principal, the point being to
structure incentives so that the agent will act to benefit the principal.

Scholars define an agency relationship 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 and authority to the agent.

The principal-agent theory of organizations (“agency theory” from here on) encapsulates the
idea that public sector performance can be improved if incentive-based contracts between
different actors are implemented. Principals will be more likely to achieve their desired
outcomes, while agents will have clarity around work programs and goals. Agency theory has
had considerable influence on the theory and practice of public administration and policy since
its emergence in the 1970s. It was particularly instrumental in many high-income developed
countries through the 1980s and 1990s, with often radical public sector reforms resulting.

In such a manner, an agency problem is a conflict of interest inherent in any relationship where
any party is expected to act in another’s best interests. An agency relationship exists between
the agent (management) and the principal or stockholders (capital providers or owners) of the
firm.

For example, if both the agent and the principal are wealth maximizes (as well as all rational
people to be) then the possibility of conflict arises. The agent can take action to maximize his
own interest (be it be wealth), and this action may not necessarily be the interest of the
principal. Hence, the difference or discrepancy between the goals of the management and than
that of the owners can be an indication of the existence of agency problem.

According to Masulis (1988), conflicts may arise due to the following four reasons:

1. Managers prefer greater levels of consumption and less incentive work, as these
factors do not decrease their remuneration and the value of the company’s shares that
they own;
2. Managers less prefer risky investments and lower financial leverage, because in this
way they may decrease danger of bankruptcy, and avoid losses in their managerial
capital and portfolios;
3. Managers prefer short term investment horizon; and,
4. Managers avoid problems stemming from reductions in employment levels, which
increase with the changes in control of a company.

Murphy (1985) argues that mangers tend to increase the size of companies even if it harms the
interests of shareholders, as quite often their remuneration and prestige are positively
correlated with company size. These inclinations cause conflicts of interest between managers,
who tend to value expansion, and shareholders, who are orientated towards the maximization
of the value of their shares. If sufficient internal funds are available, managers may be
motivated to undertake investments of dubious profitability that would be rejected by the
capital market.

In short, agency problem is perceived as a conflict of interest between agents and principals in
the process of their principal-agent relationship. To resolve these conflicts, agency costs are
always proposed.

II) Agency cost

Moyer and et al (1992) argue that agency costs are the costs which arise from the conflict of
interest among shareholders, bondholders and managers. To insure the goals of the
management with the goals of the owners, shareholders can institute incentive measures and or
monitoring steps. They may be defined as costs of resolving conflicts. Brigham and Gapenski
(1993:21) define agency cost as ‘all costs borne by shareholders to encourage managers to
maximize shareholder wealth rather than act in their self interest.’

Agency costs are a kind of transaction costs connected with way in which a firm is organized.
They are real costs which depend on legal regulations and the willingness of the people to sign
contracts, among others. Agency costs are invariably present in every organization and at all
levels of management, and brone by shareholders.

Hence, the principal can limit divergences from his interest by establishing appropriate
incentives for the agent and by incurring monitoring costs designed to limit aberrant activities
of the agent. In some situations the principal may pay the agent to expend resources (bonding
costs) to guarantee that he will not take certain actions which would harm the principal or to
insure that the principal will be compensated if he does take such actions (Jensen & Meckling,
1976). However, 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 view point.

Types of agency cost which can be identified include monitoring (for example auditing),
structuring, opportunity and guarantee or insurance cost. According to (Jerzemowska, 2006;
Jensen & Meckling, 1976) agency costs are the sum of:

 The monitoring expenditures of the principal

 The bonding expenditures by the agent
 The residual loss

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 those decisions which would maximize the welfare of
the principal.

Residual loss is the reduction in the value of the firm that arises when the entrepreneur dilutes
his ownership. In the opinion of Williamson (1988) this is the key cost, since the other two are
incurred only to the extent that they yield cost-effective reductions in the residual loss. The
shift out of profits into managerial discretion, induced by a dilution of ownership, is
responsible for this loss. Monitoring expenditures and bonding expenditures can help to restore
performance toward the pre-dilution levels. The irreducible agency cost is the minimum of the
sum of these three factors.

Agency costs further include debt costs, bankruptcy and reorganization costs. The debt in the
capital structure increases beyond some point the marginal agency cost of debit begin to
dominate the marginal agency costs of outside equity and the result is simultaneous use of both
debt and outside equity. Bankruptcy also occurs when the firm cannot meet a current payment
on a debt obligation, or one or more of the other indentures provisions providing for
bankruptcy is violated by the firm.

III) Conclusion

The theory of principal agent relationship dictates the contractual relation between the agent
and the principal to achieve organizational objectives. But, when cases arise that the interest of
either of the parties can/may be on the expense of the other, agency conflict occurs. To
mediate the conflict, principals device the notion of agency costs. Agency costs are as real as
any other cost; and, the level of agency costs depends on, among other things, on statutory and
common law and human ingenuity in devising contracts.

References

Brigham, E.F. & Gapensld, L.C. 1993. Intermediate financial management. The Dryden Press:
Orlando.

Charles, Moyer., James, McGuigan., & Kretlow, Willam. 1992. Contemporary financial
management. St. Paul, West Publishing Company.

Magdalena, Jerzemowska. 2006. The main agency problems and their consequences. Acta
Oeconomica Pragensia, 14 (3): 9-15.

Masulis, R. 1988. Debt/equity choice. Cambridge: Ballinger.

Murphy, K. J. 1985. Corporate performance and managerial remuneration: An Empirical

Analysis. Journal of Accounting and Economics, Vol 30: 245-278.

Robin, Gauld. 2016. Principal-Agent Theory of Organizations. In Farazmand (eds) Global

Encyclopedia of Public Administration, Public Policy and Governance. Springer: Cham.
https://doi.org/10.1007/978-3-319-31816-5_72-1