Agency Theory: A Comprehensive Overview of Principal-Agent Relationships, Summaries of Organization Behaviour

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What Is Agency Theory?

Agency theory is the branch of financial economics that looks at conflicts of interest between people with different interests in the same assets. This most importantly means the conflicts between:

• (^) shareholders and managers of companies
• (^) shareholders and bond holders. The theory explains the relationship between principals, such as a shareholders, and agents, such as a company's managers. In this relationship the principal delegates (or hires) an agent to perform work. The theory attempts to deal with two specific problems:
• (^) how to align the goals of the principal so that they are not in conflict (agency problem), and
• (^) that the principal and agent reconcile different tolerances for risk.

Origins Of agency Theory?

During the 1960s & 1970s , economists explored risk sharing among individuals or groups. This literature described the risk sharing problem as one that arises when co-operating parties have different attitudes toward risks. Agency Theory broadened this risk sharing literature to include the so called agency problem that occurs when co-operating parties have different goals and division of labour. Specifically, this theory is directed at the ubiquitous agency relationship ,in which one party delegates work to another agent who performs that work. Agency Theory attempts to describe this relation using the metaphor of a contract. Agency Theory suggests that the firm can be viewed as a nexus of contracts (loosely defined) between resource holders.

CONFLICTS BETWEEN MANAGERS AND SHAREHOLDERS

Why conflict of interest between shareholders and management? To address the conflict of interest between shareholders and management, it is important to stress that even within the same class of shareholders, there may be conflicts, this conflict may relate to what proportion of the company’s profit should be paid in the form of dividend and what proportion should be retained for future investments and for capital investment purposes. Other potential conflicts may involve company’s ethical policies, its corporate and social responsibilities policies. The agency theory, considering the potential conflicts of interest between shareholders and management may arise as a result of several factors, some of such factors include: Reward to management Risk attitudes of management and shareholders Takeover decisions by management Time horizon of management

The interest of shareholders may include:

• (^) Increasing earning per share (EPS), and current share prices
• (^) Increasing investor ratios such as dividend per share (DPS), dividend cover, dividend yield, price-earning (P/E) ratio
• Others may include the company improving its corporate and social responsibilities

Management interest may include:

• (^) Managing the firm to achieve its objectives
• (^) Increasing the wealth and size of the company, by expanding the

company’s activities, the bigger the size of the company they

manage the better they are perceived to be.

• Increasing their personal wealth by paying themselves high

remunerations and other benefits

COSTS OF SHAREHOLDER-MANAGEMENT CONFLICT

Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. There are three major types of agency costs: (1) expenditures to monitor managerial activities, such as audit costs; (2) expenditures to structure the organization in a way that will limit undesirable managerial behaviour, such as appointing outside members to the board of directors or restructuring the company's business units and management hierarchy; and (3) opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth.

STOCKHOLDERS VERSUS CREDITORS: A SECOND

AGENCY CONFLICT

In addition to the agency conflict between stockholders and managers, there is a second class of agency conflict between creditors and stockholders. Creditors have the primary claim on part of the firm's earnings in the form of interest and principal payments on the debt as well as a claim on the firm's assets in the event of bankruptcy. The stockholders, however, maintain control of the operating decisions (through the firm's managers) that affect the firm's cash flows and their corresponding risks. Shareholder-creditor agency conflicts can result in situations in which a firm's total value declines but its stock price rises. This occurs if the value of the firm's outstanding debt falls by more than the increase in the value of the firm's common stock.

AGENCY VERSUS CONTRACT

Although the notions of agency and contract are closely intertwined, some academics bristle at the suggestion they are essentially the same. A conventional view holds that agency is a special application of contract theory. However, some argue that the reverse is true: a contract is a formalized, structured, and limited version of agency, but agency itself is not based on contracts

Key idea

• Principal-agent relationships should reflect efficient organization of information and risk- bearing costs Unit of analysis • Contract between principal and agent Human assumptions
• Self-interest • Bounded rationality • Risk aversion Organizational assumptions
• Partial goal conflict among participants • Efficiency as the effectiveness criterion Information asymmetry between principal and agent Information assumption
• Information as a purchasable commodity Contracting problems
• Agency (moral hazard and adverse selection)• Risk sharing Problem domain
• Relationships in which the principal and agent have partly differing goals and risk preferences (e.g., compensation, regulation, leadership, impression management, whistle- blowing, vertical integration, transfer pricing)

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