Researching Agency Cost Problems

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Corporations play a central role as far as the modern economy is concerned. This is because all or majority of the economic activities are usually performed by firms. The following essay is thus concerned with the examination of the agency cost problems in corporations. The essay is thus composed of an introduction that talks about the overview of the agency cost problem, the general discussion of the agency cost problem and the conclusion as a result. The recommendations, suggestions as well as the opinion are also discussed.

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Introduction

An Agency relationship arises whenever the principal contract an agent to perform certain tasks on his or her behalf and delegate the relevant decision making authority to the agent.Whenever there is an agency relationship, a conflict or problem may arise if an agent decide to pursue his interest on the expense of the principal. In the context of corporate centre, an agency conflict can arise between the following; ordinary shareholders and management, ordinary shareholders and debenture holders, ordinary shareholders and independent auditor and finally ordinary shareholders and the government. The resolution to the conflicts however is incurring the agency cost. These are the costs that are borne by the shareholders as a result of them not being involved in the decision making of the organization. These costs are incurred to harmonize the interest of the shareholders and management and to ensure that the company runs in a manner acceptable to the owners (Giinter 18).

Concept of agency costs

Gardiner Coit and Adolf Augustus were the proponents of the agency theory concept and its applications in large companies. They thus held the view that both the managers as well as the directors have interests that differ from the interests of the shareholders and so the conflicts are bound to arise. The works of these proponents was later formally shaped by William Meckling and William Jensen in 1970s.The two argued that firms are usually structured with a view of minimizing agency costs. The theory holds the view that when different players in a particular situation have a common goal, then they will develop different motivations which can exhibit in various ways. The theory further argues that conflicts will always be common as far as the parties are concerned and thus efficiency as well as the effectiveness must work together so as to cater the interests of both the principal and the agent. Agency theory remains an important concept and has been applied in numerous subjects among them finance, accounting e.t.c. (Ross 55).

According to William Meckling and Michael Jensen, agency costs exhibits in three major forms i.e., contracting costs, monitoring costs and opportunity costs. Contracting costs are costs that are incurred in devising the employment contract between managers and shareholders. Its purpose is to spell out clearly the duties and obligations of each part so as to minimize disagreement between the two parties e.g. negotiation fees, legal costs of drawing employment contracts, cost of setting performance standards e.t.c.

Monitoring costs are costs that are incurred to prevent undesirable management actions. They are meant to ensure that both parties live to the spirit of agency contract. They ensure that management utilize financial resources of shareholders without undue transfer to themselves e.g. external audit fees, the cost of investigations constituted by shareholders e.t.c.

Opportunity cost on the other hand is the forgone benefit due to failure of both the shareholders and directors to act optimally e.g. lost opportunities due to inability on the part of management to make quick decisions as a result of tight internal control systems (Ross 55).

Who bears the agency costs and the reason as to why?

The shareholders usually bear the agency costs. The shareholder lacks the capacity to run the firm and therefore appoints the management to run the firm on their behalf. They thus delegate the relevant decision making authority to the management. The shareholders contributes capital and on the other hand, the management is expected to utilize the capital in running the business with the aim of attaining ultimate objective of maximizing the wealth of the owners. In most case, the owners will not take part in management of the business due to some reasons as follows; they lacks the relevant technical as well as management skills, they don’t have time to fully participate in the management, owners may be too many and so they can’t all run the firm and finally, the corporate governance requires that there should be separation between ownership and management. The management is expected to report to the owners during annual general meeting on how they have run the business and this is referred to as stewardship accounting (Bainbridge 67).

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Relationship between agency cost and control

Agency cost usually occurs as a result of divergence of the control. The management is required to carry out the business in a profit manner but if they misappropriate the company’ resources, then the agency costs are bound to arise. The management may also create agency cost by spending huge sum of money on entertainment, financing trips to far regions, office decoration, awarding themselves huge salaries and fringe benefits. Management usually describes the compound behaviors of the persons who are responsible in making the decisions regarding effective allocation of the firm’s resources. Their roles is thus multifunctional i.e. they are involved in decision making, providing strategic leadership, mediating both the firm as well as the society among others. Their decision thus can contribute to the agency costs. Restructuring costs which are costs incurred to harmonize the interest of the shareholders and management is also common in firms. This cost can however be harmonized pegging or attaching managerial compensation. This will involve restructuring the remuneration skill of the firm in order to harmonize the interest of shareholders and management. If the management fails to act optimally, then the agency cost are bound to arise e.g. failure to undertake high risk, high return projects by a manager often leads to loss of profits. In the United States, there is separation of control and ownership among many firms. The shareholders virtually have no control over the daily operations and instead, the managers have the control of the firm. This separation of control as well as ownership of the firms in the United States is associated with agency costs.

Agency costs can also arise in a situation where a majority shareholder decides to sell all or a portion of his or her shares. This is due to the reason that the initial owners’ incentive is changed as the owner can no longer be responsible for the costs arising from the decision of the firm. Thus when a company conducts an initial public offer, there is diffusion with regards to ownership and hence agency costs increases due to a decreased control (Jensen & Meckling 98).

How outside equity and debt generates agency costs

Debenture holders are providers of long-term debt capital. They lend on conditions that they will be paid debenture interest and the principle amount on maturity. Therefore, debt holders as the principle entrust their firms to shareholders who in turn becomes the agent. The initial lenders can be put into more risks through such actions as payment of high dividends by the firm, disposal of asset used as collateral for the debt, investment substitution among others.

Pareto optimality and existence of agency costs

Pareto efficiency as economics is concerned with the efficiency in assets allocation and income distribution and a location is regarded as Pereto efficient when there is nothing much that can be made to improve it. The agency costs arise once the firm fails to allocate the resources optimally (Lukas 189).

Adverse selection, moral hazards and agency costs

Both moral hazards as well as adverse selection can result to agency costs. Moral hazards arises when both parties refuses to be fully responsible for their actions and hence the tendency not to pay attention to minor details and hence the increase in costs. Usually, either the directors or the shareholders may have more information than the other and so, the party with more information may behave in a manner that is careless and hence incur the agency costs the management thus may make risky decisions with a view that the shareholders will bear the cost once things don’t go according to the plan. It is thus important for the management to consult with the shareholders before lending. The management must be answerable for the consequences of the lending decisions that they decides to undertake without the awareness of the owners of the firm (Lukas 189). Whereas moral hazard is concerned with hidden action, adverse selection on the other hand relates to hidden information. Moral hazard usually occurs when a particular decision by the top management is not observable and has a value to directors more than the owners. In adverse selection, problems occur when the top management possesses more information as compared to shareholders. Both the problem of adverse selection as well as moral hazards usually occurs during the initial public offer of a firm. During the initial public offer, conflicts associated with adverse selection as well as moral hazards may arise as a result of such aspects as undervaluing the value of the firm’s assets e.t.c. This in turn contributes to agency costs (Lukas 189).

Agency cost of free cash flow

This refers to the costs that result from the conflict between the owners and managers. The top management of a firm may take some actions which are inconsistent with the goals of the shareholders or the shareholders may act in a way that is against the interest of the directors. This may cause suspicion between the two parties and hence a conflict. The sources of this form of conflict

Includes the following; incentive problem i.e. managers or directors have a fixed salary and may not have the incentive to work hard to maximize the shareholders’ wealth. This is because irrespective of the profits they make, their reward is fixed. Therefore, the directors end up only working to produce satisfaction but not to maximize results. They will also maximize leisure and this is against the interests of the shareholders.

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Agency cost of free cash flow may also arise as a result of consumption of perks (Mauer & Ott 16). This refers to the high salaries and generous fringe benefits which top management award themselves. This will in turn result to a reduction of dividends payable to the ordinary shareholders and therefore, the consumption of perks is against the interest of shareholders as it reduces their wealth.

Another aspect of agency cost of free cash flow is differences in risk profile. Usually, shareholders will prefer high risk, high return investments based on the assumption that they are well diversified i.e. they have multiple investments and the collapse of one firm may have insignificant effects on their overall wealth. Managers on the other hand would prefer low risk low return investment since they have a personal fear of losing their jobs if the firm collapses as a result of undertaking a high risk project. Therefore, the directors will always undertake low risk projects against the wishes of shareholders hence the conflict and hence the agency costs.

Another source of conflict is the evaluation of time horizon. Managers prefers to undertake projects which are profitable in the short run to middle term when they are still in employment of the company so that they may take credit for their work. Shareholders evaluate investment in the long run horizon which is consistent with the going concern aspect of the firm. A conflict of interest will arise hence an increase in agency cost since managers will pursue short term profitability while shareholders will pursue a long-term profitability.

The management buyouts commonly termed as MBO may be a source of conflict and agency cost in that, the board of directors may attempt to acquire the business of the principle. They may do this by recommending a take over or selling of shares at the stock exchange when they have formed Nominee Company to acquire shares. This is inconsistent with the agency relationship and contract between the shareholders and the directors (Giinter 18).

Undisclosed interest and transaction is another aspect that increases the agency cost and conflict.It arises where managers undertake projects in which they have an interest but without disclosing this to shareholders e.g. getting supplies from firms belonging to the relatives and friends and therefore the directors make again behind the back of the shareholders and hence a conflict.

Manipulation of the financial statement through the change of accounting policies to misappropriate funds e.g. change in method of depreciation so as to reduce profits and the change in the method of valuing inventory. This often leads to conflicts and hence an increase in agency costs.

Others include the embezzlement of funds and mismanagement of funds as well as engagement in similar business as a business of the shareholders (Giinter 18).

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Conclusions

The problem of agency cost is an important concept of understanding how a modern firm operates. For instance, the corporate managers usually pursue objectives which will safeguard the interest of the shareholders. The expenditures that are incurred in monitoring is useful with regards to the agency costs are concerned. Since the management is vested with the role of making decisions, there is need for the management to ensure that they come up with optimal decisions that will help to curb the agency cost.

Recommendations

Monitoring efficiency is the key to countering the agency cost. Efficiency helps to reduce the monitoring costs. The management should ensure that they utilize the financial resources of the shareholders without undue transfer to themselves e.g. external audit fees, the cost of investigations constituted by shareholders e.t.c. duties and obligations of each party should be spelled out clearly so as to minimize disagreement-related costs such as negotiation fees, legal costs of drawing employment contracts, cost of setting performance standards e.t.c. Managers or directors should have a voluntary code of practice which should guide them during the performance of their duties. Shareholders on the other hand should intervene in various ways such as making recommendations to the management on how the firm should be run by sponsoring proposals to be quoted in the annual general meeting.

Another way of reducing the agency cost implies the shareholders to monitor the operations of the management to ensure that the agent performs only what he has is supposed to do only. This however can be expensive too.It may also be challenging to determine the duties of an agent in a manner that can be well monitored e.g. it is not easy to determine as to whether an agent who was involved in those expanding the company through mergers that brought about a reduction in the value of its shares was indeed pursuing his or her own interests or had an intention of increasing the wealth of the shareholders but was not lucky.

Another aspect that can help to minimize the agency costs is to ensure that the managements’ interests are more or less like those of the shareholders e.g. giving management a special class of shares which is commonly referred to as employee share option plan. This share entitles the management dividends at the end of the year and this will motivate them to increase profits of the firm.

Firing or threat of firing is also an important aspect of minimizing the agency costs. Shareholders have the power to hire and fire the directors at the AGM. The entire management team may be fired or threatened with action in case of poor performance (Mauer & Ott 13). This will force them to act in the best interest of shareholders.

An increase in agency costs usually makes the shares of a firm to be undervalued and therefore the shareholders can threaten to dispose of their shares to competitors in which case the management team will lose their jobs and those who stay in the new firms will lose their control and influence. This threat is also adequate to give incentives to the management and to ensure that costs are controlled (Lasher 19).

Suggestions

Agency cost problems is as a result of the asymmetric information between the management and the shareholders. The organizational structure has the effect of separation of the ownership as well as the control of the firm. Separation results to the asymmetrical information. In order to counter the consequences of the asymmetric information, the shareholders should monitor the operations of the management or the agents. The monitoring activities should include accountability of the funds, preparation of the budgets as well as setting the limits upon which spending should be done. Monitoring will thus help to reduce the occurrence of a moral hazard.

Opinion

Agency costs manifests itself in a situation where there is lower profitability which is as a result of poor management and therefore the shareholders should insist on a more independent body as far as the companies operations are concerned so as to help minimize the agency costs. Our opinion is thus, if agency costs are to be increased, then there must be an increment in the benefits of the shareholders as a result.

References

Bainbridge, Stephen. The new corporate governance in theory and Practice. London: Oxford University Press, 2008.

Giinter, Bamber. Agency theory, information and incentives. Berlin: Springer-Verlag, 1987.

Jensen, Michael & Meckling, William.Agency costs and ownership structure. New York: Social Science Electronic Publishing (SSEP), Inc.

Lasher, William. Practical Financial Management. Stamford: Cengage Learning, 2007.

Lukas, Junker. Equity carves outs, agency costs, and firm value. California: DUV, 2006

Mauer, David & Ott, Steven. Agency costs and optimal capital structure: The Effect of growth options, Working Paper. Miami: University of Miami, 1996.

Ross, Stephen. Fundamentals of corporate finance. New York: McGraw-Hill/Irwin, 2006

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