Agency Problem in

Corporate Governance
TOPICS:

 Agency Problem definition

 Agency Problem & Parties Involved
 Prevention of Agency Problem
 Agency Costs
 Types of Agency Cost
 Principal-Agent Relationship
 Reducing Agency Cost
AGENCY PROBLEM
It refers to a conflict of interest between a company’s
Management and the company’s Stockholders.

Stockholders want to maximize the wealth of the firm but

Management wants to increase their personal benefits.

Thus, with the objective of survival, management would

aim at satisfying instead of maximizing shareholder’s
wealth.
Agency Problem & Parties Involved

Stockholders vs Manager
• In theory, managers would agree with stockholders wealth
maximization, however, managers are also concerned with
their personal wealth, job security and fringe benefits.

• Managers may make decisions that are not in line with

the goal of maximizing stockholders wealth.
Agency Problem & Parties Involved
Stockholders vs Creditors
• Shareholders (through managers) could take actions to
maximize stock prize that tend to cause harm to
creditors.
• Example: stockholders might push management to
take up a project that has high returns but also high risk
• If the venture is successful, all the benefits accrue to
stockholders; creditors just get a fixed return
If things go bad the creditors will have to share the losses
Agency Problem & Parties Involved
Stockholders vs Other Stakeholders
• Other Stakeholders (employees, suppliers, customers &
communities) may have a different agendas and may want
to monitor the behaviour of equity holders and
management.
• Example: owners want to pay inadequate salary but
employees want to increase their salary to a sufficient level.
• Such conflicts between stockholders and other
stakeholders create agency problem.
Prevention of AGENCY PROBLEM
The agency problem can be prevented by:
 Market Forces
 Agency Costs

Market Forces
It is of two types:
 Behaviour of security market participants
 Hostile Takeovers
Market Forces
Behaviour of security market participants
The participants include institutional investors (mutual
funds, insurance, etc.) actively participate in
management. They use their voting rights to replace
more competent management.

Hostile takeovers
It is the acquisition of the firm that is not supported by
management. The constant threat of takeover motive
management to work for maximising owner’s wealth.
Agency Costs
 Agency costs are internal costs incurred due to the
competing interests of shareholders (principals) and the
management team (agents).
 It is the expenses that are borne by shareholders to
prevent agency problem as to maximise owners wealth.
Types of Agency Costs

AGENCY COST

MONITORING BONDING OPPORTUNITY STRUCTURING

Types of Agency Costs
 Monitoring Expenditures
Such expenditures relate to monitoring the activities of
the management to prevent a satisfying in contrast to share
price maximizing behaviour by them.

It relates to the payment for audit and control procedures

to ensure that management is working for maximising
owner’s wealth.
e.g. Auditing financial statements
Types of Agency Costs
 Bonding Expenditures
It protects the owners from the consequences of
dishonest acts by management / managers.

The firm pays to obtain a fidelity bond from a third-

party bonding company the effect that the latter will
compensate for financial loses due to dishonest acts
Types of Agency Costs
 Opportunity Costs
Such costs result from the inability of large corporate
from responding to new opportunities.

Due to the organizational structure, decision hierarchy,

the management may face difficulties in seizing upon
profitable investment opportunities quickly.
Types of Agency Costs
 Structuring Expenditure
The most powerful and expensive approach is to
structure management compensation. The motive is to
give managers incentives to act in the greatest interests of
the owner.

It is of two types:
1) Incentive Plans
2) Performance Plans
Incentive Plans
• These tend to tie management compensation to share
price
• The most widely used plan is stock options which allows
management to acquire shares at special prices.

Performance Plans
• These plans compensate management on the basis of its
proven performances
• Performance shares are given to management for
meeting the stated goals.
The Principal-Agent Relationship
The principal-agent relationship plays a major role in agency
costs. The principal-agent relationship is an arrangement
between two parties in which one party (the principal)
legally appoints the other party (the agent) to act on its
behalf.

The principal-agent problem occurs when the interests of the

principal and agent are not aligned. As a result, agency costs
are incurred.
Reducing Agency Costs
The most common way of reducing agency costs in a
principal-agent relationship is to implement an incentives
scheme.

There are two types of incentives:

 Financial Incentives
 Non- financial Incentives
Reducing Agency Costs
Financial Incentives
Financial incentives are the most common incentives
scheme. Financial incentives based on performance help
motivate agents to act in the best interest of the company.

Examples:
o Stock options
oProfit-sharing
Reducing Agency Costs
Non-financial Incentives
Non-financial incentives are less commonly used and are
often not as successful at reducing agency costs, as
compared to financial incentives.
Examples:
oNew office or workspace
oTraining opportunities
oRecognition from co-workers
oCorporate car
Thank You!