The topic under study in this term paper is agency cost problems that arise in corporations. The term paper will cover an introduction to the topic with the concept of agency costs being explored and discussed. The discussion will also focus on the concept of agency relationships that especially exist between shareholders (principals) and agents (managers). The paper will also cover important topics that are related to agency cost problems with a particular focus on the business operations and activities of an organization. The agency costs in corporations will be discussed as well as the problems that might arise as a result of agency costs within the corporation. The paper will also cover the factors that need to be considered before the company incurs any agency costs. The discussion will also cover the relationships that lead to agency costs within corporations and the main players of these relationships.
An agency cost problem is defined as a cost that arises due to the core problems that a company experiences when its shareholders and management experience a conflict of interest. These conflicts of interest usually arise when the shareholders hold an opinion or view of how managers should run the company which is contrary to what the company’s management view as the proper way of running the company. Managers usually have their own vision of how the company should be and they accomplish such visions by utilizing their personal power and authority which might conflict with the interests of shareholders. As a result of this, conflicts of interest arise within the company as to how the assets and finances of the company should be managed and maintained. Agency costs, therefore, arise when the company involves the services of an agent to act on behalf of a principal member of the company which in this case is the shareholder of the company (Kleiman par.1).
Definition of Agency Costs
Agency costs are defined as the costs that are incurred by an entity such as a corporation, business firm or organization when dealing with management-shareholder conflicts. Agency costs in most corporations are costs that are unavoidable especially in the case where the corporation’s principals do not have complete authority over the company. Agency costs are usually spent on aspects such as performance bonuses and stock options to ensure that the shareholders have proper incentives to the company’s shares. Agency costs are also used as moral incentives for the agents that are used by principals to ensure that they perform their duties, reducing the level of conflict that exists between the principals and the shareholders. Agency costs are therefore economic aspects that a company has to consider in the event its principals run into a conflict with shareholders. Despite the fact that agency costs exist in every agent-principal relationship, these costs are mostly common in businesses (Kleiman par. 1).
Agency costs are usually paid by the company’s shareholders to encourage the executives and managers of the company to conduct shareholder wealth maximization activities that will meet the interests of the shareholders. Agency costs are divided into three categories and they include expenses that will be used to monitor the activities of a company’s managers, expenses that will be incurred when structuring the activities of an organization to limit undesirable management behavior and expenses that will be incurred when shareholders imposed restrictions limit the ability of the company’s board of directors and managers to take actions against shareholder interests that seek to increase the wealth maximization of the company’s shareholders (Kleiman par. 8).
The three types of agency costs are meant to deal with managerial or shareholder behavior that was deemed to be detrimental to the market value and market share of the company. Agency costs arise when the efforts of a company’s shareholders are absent or lacking when dealing with inappropriate managerial actions and behavior. When the shareholders decide that management actions should conform to their own personal interests, the company is more than likely to incur agency costs. These costs also arise when the agents used to manage shareholder-management conflicts incorporate their own self-interests in the management of these conflicts. Agency cost problems are detrimental to the image and reputation of a company that seeks more investors and stockholders to invest in the shares and common stock held by the company (Kleiman par. 9).
Company Considerations for Agency Costs
Before a company decides to incur agency costs, two important factors need to be considered when using agency costs to deal with shareholder-manager conflicts. These factors include the costs that will be incurred in using an agent such as consultancy fees and financial resource allocation and the cost of the techniques that will be used by the agent. The aspect of using an agent should be considered by managers of a company as an important factor especially if there is a risk that the agent will use the resources of the company to achieve their own personal benefit. Such a risk is an important consideration if the company does not want to incur additional expenses to agency costs (Kleiman par. 20).
The cost of the techniques or approaches that will be used by the agent to deal with the problem should also be considered by the principals as some techniques can prove to be more costly than others. Techniques such as those used in determining the cost of producing financial statements might prove to be costly for the company which might then decide to use other cheaper alternatives. Techniques and approaches in agency costs could therefore be used in determining the cost of producing financial statements such as income statements, balance sheets and financial reports to deal with the management-shareholder conflict. They can also be used to determine the cost of using stock options to deal with the management-shareholder problem or to identify the cost of aligning the interests of managers with the interests of the shareholders (Kleiman par. 21).
Agency Cost Problems in Corporations
The theories that exist on agency costs stipulate that a company or corporation is viewed as a nexus of contracts that exist between the various stakeholders of the company. These nexus of contracts at times lead to conflicts that form agency relationships where two or more individuals with a vested interest in the company such as stock or share ownership decide to use other individuals to perform services for them. The most common type of agency connections that exist within the business context is those amid managers and investors and those that exist amid bondholders and investors. At times these relationships are not usually harmonious and peaceful which means that agency theories have to be used to deal manage stockholder-manager conflicts and shareholder-bondholder conflicts (Kleiman par.1).
Agency theories have therefore been developed as dominant models that can be used to manage the relationships that exist between shareholders and managers within a company. The conflicts that arise as a result of varying self-interests held by the various actors of the company usually lead to corporate governance and business ethics problems. Agency relationships that are formed to deal with shareholder-management conflicts usually lead to agency costs and expenses that are incurred by an organization to ensure that the relationships have been properly sustained. Such agency costs might include offering managers incentives or performance bonuses to represent the interests of the company’s shareholders when conducting stock investments, company share buyouts and employee stock options (Kleiman par. 1).
Agency cost problems usually arise when the managers or shareholders of a company decide to pursue their own self-interests instead of interests that might benefit the company and its shareholders as a whole. For example, an agency cost problem might arise in the event that a company’s management decided to own 100 percent of the company’s stock. Such a situation usually occurs in sole proprietorship companies where the owner chooses their own self-interests to maximize the welfare of the company. If the owner of the company decides to sell off some of their stock, thereby foregoing a portion of the company’s ownership, an agency cost problem will likely occur in reconciling the ownership of the company. The owner might decide to sell off stock so as to maximize shareholder wealth because a lesser amount of the wealth will accrue to the owner of the company. An agency cost conflict might also occur when the owner or manager of the company decides to use more company perquisites which means that the cost of such benefits will be paid by outside investors (Kleiman par.5).
Many large publicly traded corporations around the world face constant agency conflicts because the managers of such companies own a small percentage of the company’s stock. This forces some managers to subordinate shareholder wealth maximization activities with their own personal goals and interests. For example, the managers of a company might have a personal interest in maximizing the size of the firm to achieve business objectives. By creating a large and rapidly globalized company, the managers pursue their own personal self-interests, which improve their personal status, job security as well as improve their compensation benefits. Such self-interests held by managers, therefore, lead to agency cost problems as additional expenses have to be incurred to deal with shareholder-manager conflicts (Kleiman par. 6).
Information asymmetry has been identified as one of the major causes of agency cost problems in many organizations and business firms. This is because the information asymmetry that exists between the shareholders and managers of a company contributes to adverse selection problems and moral hazards within the organization. As explained before in the introduction, agency costs arise as a result of manager-shareholder conflicts where the interests of the shareholders are in conflict with the objectives and visions of the managers. Adverse selection problems, therefore, occur when the costs are used for divergence control to ensure the business operations are not affected by the conflict and in the separation of ownership in the event, the company’s shareholders want to separate themselves from the company (Garger par.3)
Selection problems also arise when the business goals of the company’s management are deemed to be more important than those of the shareholders. Moral hazards usually arise when a company runs into debt, foreclosure or bankruptcy, a situation that might force the company’s shareholders or managers to pursue selfish strategies that might see the company incurring agency costs that lower the market value and market share of the company. Agency cost problems also occur when whenever many principal-agent relationships exist in one company. Many modern corporations that are complex in nature have so many shareholders that it becomes necessary to involve the use of many agents to manage shareholder-management conflicts. These simultaneous principal-agent parings usually make it difficult for the company to adequately satisfy the needs of shareholders (Garger par.2).
The connection that exists between the staff of the company and its proprietors is termed to be an agency relationship. This type of relationship creates agency cost problems when the interests of the employee conflict with the interests of the managers. For example, employees who travel to conduct normal business activities incur expenses such as travel costs, accommodation and meals. If the employee decides to plan their own travel itinerary with the permission of the company’s management, an agency cost problem is likely to occur in the event the employee overspends on accommodation or meal costs (Garger par. 3).
If an employee stays in a five-star hotel and decides to take advantage of the hotel’s expensive services, the equity that is held by the company’s owners and management will reduce considerably because of these high-cost expenses which are deemed to be unnecessary expenditures for the company. Agency problems will therefore arise as a result of the asymmetric information that exists between the employee and the company’s managers/owners. According to Garger, “the corporate structures that usually exist in many organizations normally lead to separation of control and ownership of the company”( par.4). Agency cost problems are likely to occur in the event the company’s shareholders decide to separate the control of the company’s managers in the event they own a large percentage of the company’s stock (Garger par.4).
Agency cost problems within corporations also occur as a result of the company’s inability to monitor agents. The principle that exists on self-interests in agency costs stipulates that in the event the company fails to monitor the activities of the agents, they will act out of their own self-interests when dealing with shareholder-management conflicts. Many large-scale companies usually incorporate the use of monitoring systems to reduce the effects of asymmetric information which might lead to agency cost problems within the company. The agency cost problem arises because its impossible to properly monitor an agent who incurs costs such as managerial behavior monitoring costs, agent costs and shareholder costs. When the monitoring procedures incorporated by the company fail to inspect properly the activities of the agent during the shareholder-management conflict resolution exercise, a moral hazard usually arises from such a situation (Garger par.5).
Moral hazards occur when the agents decide to utilize the resources allocated to them for activities other than those of conflict management of the company’s assets. They also occur when the agents decide to act in an unobserved and self-interested manner considering their own self-interests instead of those of the company. Monitoring costs to prevent moral hazards are usually high and once the agent is found to be a moral hazard, the company experiences agency cost problems. Despite the level of monitoring that a company might exercise, there will always be cases where the agents behave in an unobservable way. Policies that are implemented to monitor the activities of the agents will prove to be too costly for the company especially where the agency costs of an agent working for their own interests are higher than the company’s monitoring costs (Garger par. 6).
Principal-Agent Relationships that Contribute to Agency Cost Problems
The relationship that exists between the shareholders of a company and the managers is usually considered to be the main cause of agency cost problems within a company. The agent who in most business companies is an executive or manager acts on behalf of the principal who is the company’s shareholder to ensure that there are no conflicts that exist between the shareholders and the management of the company. The agency relationship, therefore, requires that there should be information asymmetry to ensure that the relationship exists. If no information asymmetry exists, then the agent’s contract should outline the relationship that is meant to link their actions with the interests of the shareholders (Garger par.3).
Agency costs are usually important when the company wants to involve the use of its directors, executives or managers as agents to manage the principal-agent relationship. This means that the principal-agent relationships that exist in major corporations are made up of various actors who involve the use of various goals and objectives to manage these relationships effectively. The various actors that exist in principal-agent relationships include managers, shareholders/stakeholders or bondholders, the company’s board of directors, labor and other stakeholders that have a vested interest in the company (Kleiman par. 22).
Managers affect the principal-agent relationship when they decide to pursue their own personal goals and objectives instead of the goals and objectives of the company. Managers or chief executive officers of most major corporations usually put their own needs and ambitions before those of the shareholders. These ambitions and objectives usually take the form of business expansion, risky investments, company mergers, buyouts, company acquisitions and the manipulation of financial figures to optimize shareholders’ stock options and bonuses. The personal objectives of managers usually lead to shareholder-management conflicts which erode the stockholder value of shareholders ruining the image of the company as a suitable investment option. Shareholders are other major actors in the principal-agent relationship as they have the power to determine whether they will gain their investments back (Kleiman par.22).
Bondholders are different from shareholders in that they involve the use of risk-averse strategies when they invest in company projects to ensure that they gain their initial investments. Bondholders rarely invest in risky projects and if they do, they usually exercise a lot of caution when carrying out their investments. Bondholders affect the principal-agent relationship especially in the event that the company’s management decides to engage in risky investments and projects. The conflict of interest will be that the bondholders do not want to invest in risky projects that might not return their original investment. In the case of shareholders, their investment activities involve the use of risk-taking strategies when investing in risky projects (Kleiman par. 14).
In the event that the risky projects succeed, they take all the profits from their investments for themselves. If the project fails, however, the risk is usually shared between the shareholder, the company’s managers and the bondholders who had invested in the project. Bondholders are usually aware of such risks which means that they have contracts in place to prohibit managers from taking on very risky projects. The principal-agent relationship arises when shareholders decide to invest in risky projects that the company’s management views to be high in risk. A conflict of interest emerges when the company’s shareholders view the risky venture to be a worthwhile investment for the company while the managers view the investment to be nothing more than a risky investment (Kleiman par.15). A company’s board of directors is usually made up of members who make major decisions about the direction that the company will take in both the present and the future. Boards of directors usually have their interests and objectives aligned with either the interests of the company’s management or the interests of the shareholders. This alignment is usually determined by the type of risk that is involved in the investment and also the type of interests that have brought about management-shareholder interests. The role of the board of directors in the principal-agent relationship is to ensure that the conflicts have been resolved. They also ensure that the conflicts do not interfere with the company’s market value and share value (Kleiman par. 10).
Labor which includes the employees of a company is usually aligned to the stockholders of the company and at times the management. Labor involves the use of risk-averse strategies when it comes to stock options investments because it cannot diversify itself when compared to shareholders who can be able to diversify their stake in equity investments. Employees are important in principal-agent relationships because they prevent any job losses from occurring within the organization by undertaking risk-averse investments for the company. Such projects reduce the risk of the company going into bankruptcy or running into financial debt which might in the end lead to major job losses and downsizing (Kleiman par. 10-11).
Employees are important in principal-agent relationships as they are able to influence the decisions of managers to take on risk-averse projects that will prevent the company from hostile takeovers which also lead to job losses. Employees, therefore, give managers some considerable leeway when the executives decide to explore risky investment activities given that the managers have been performing their work duties well. If the management of the company is however underperforming, the employees have the power to inform stockholders about how their stock options and shares are being managed. Other stakeholders that contribute to the agency cost problems experienced by most organizations include governments, suppliers and customers or clients of the company (Kleiman par. 12).
Since the above groups have their own specific interests to take care of, the company will incur additional costs to meet this group’s specific needs and interests. Agency costs that are used to deal with government-management conflicts that might arise within a company include government activities conducted by the company that is deemed to be a waste of taxpayers money, public conflicts between the government and the general public where the public might want their tax money to be used on important activities that are beneficial to the general society. The above actors contribute to the conflicts that arise in management-shareholder problems that also contribute to agency cost problems within a company (Kleiman par. 11-12).
The above discussion has focused on the topic of agency cost problems that arise within corporations and business enterprises as a result of shareholder-management conflicts. The paper has analyzed the definition of agency costs and it has also looked at agency cost problems that might arise as a result of management-shareholder conflicts within the company. The discussion has also dealt with the various types of conflicts that lead to agency costs as well as agency relationships that exist within organizations that have incurred agency costs to manage these relationships. According to the findings, agency costs and agency cost problems are occurrences that are likely to occur when managers or shareholders place their self-interests first.
Garger, John. Principal-agent relationships: agency problems, monitoring and moral hazards. Bright Hub. 2010, Web.
Kleiman, Robert. Agency theory. Reference for Business, n.d. Web.