Agency relationships & costs

8/7/2019 Agency relationships & costs

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- Introduction

-Resolving agency problem


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` In proprietorships, partnerships owners are actively

involved in management.

` But in companies, especially large public limited

companies, owners are typically inactive managers.

` They entrust this responsibility to professional managers

who may have little or no stake in the firm.

` This is the main reason for conflicts between managers

and owners of the company.


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` Most enterprises require large sum of capital to achieve

economies of scale. Hence it becomes necessary to pool capital

from thousands of owners. It is impractical for many owners to

participate actively in management.

` Professional managers may be more qualified to run thebusiness because of their technical expertise

, experience and

personality traits.

` Separation of ownership permits unrestricted change in owners

through share transfers without affecting the operations of the

firm.

` Given uncertainties , investors would like to hold a diversified

portfolio of securities. Such diversification is achievable only

when ownership and management are separated.


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An agency relationship arises whenever one or moreindividuals, called principals,

(1) hires another individual or organization, called an

agent, to perform some service and

(2) then delegates decision-making authority to that agent.


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` A potential agency problem arises whenever the manager of

a firm owns less than 100 percent of the firms common

stock, or the firm borrows. You own 100 percent of the firm.

An agency problem could exist between you and your

employees if you, the principal, hired the employees to

perform some service and delegated some decision-making

authority to them.

` cquiring outside capitalcould lead to agency problems.


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` TheAgent is responsible for acting on behalf of the

principal. Its highly possible that agent will act in his orherpersonal interestbecause the agent has his or her

own objective ofmaximizing personal wealth.

` In large corporations the mangers enjoy fringe benefits.

These benefits may be helpful to conduct business andmay help to retain or attract management personnel.

There is a possibility that managers who feel secure in

their positions may notbother to expend theirbest

efforts toward the business.


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1. Conflicts between stockholders and

managers.

2. Conflicts between stockholders and

creditors.3. Conflicts among stockholders,

managers, and creditors.


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` A decision must be made either to liquidate the firm byselling off its assets or to reorganize it and let it continue as a

going concern.All bankruptcy reorganizations involve

intense negotiations between creditors, stockholders, and

managers.

Creditors may want to liquidate, so as to get their funds

relatively quickly.

` Managers generally want to preserve their jobs, hence to

reorganize.

` Stockholders also want reorganization. Otherwise, they facegetting nothing, or next to nothing, in liquidation.

` But managers may be willing to give too much to creditors

to get agreement, at the expense of stockholders.


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` An agency cost is an economic concept that relates to the costincurred by an entity (such as organizations) associated with

problems such as divergent management-

shareholderobjectives and information asymmetry. The costs

consist of two main sources:

` The costs inherently associated with using an agent (e.g., therisk that agents will use organizational resource for their own

benefit) and

` The costs of techniques used to mitigate the problems

associated with using an agent (e.g., the costs ofproducing financial statements or the use ofstock options to

align executive interests to shareholder interests).


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` It is a lost opportunity.

` Management may fight acquisition of their firm by

other firm even if the acquisition would benefit

shareholders.` Because in most takeovers, management personnel

loose their jobs.


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` Th

e agency problem can be prevented / minimizedby acts of :

Market forces

Agency costs


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` The security market participants / Shareholders and largeinstitutional investors like mutual funds , insurance

organizations which hold large blocks of shares of

corporate actively take part in management.

` They exercise their voting rights to replace morecompetent management in place of under-performing

management.

` They also from time to time communicate with, and

exert pressure on corporate management to perform orface replacement.


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` Acquisition of firm by another firm that is not

supported by management.` Such takeover typically occur when the acquirer is of

the view that the target firm is undervalued due to

poor management and that its acquisition will value

the firm by restructuring its management , operationsand financing.

` The constant threat of a takeover will motivate

management to act in the best interests of the owners

despite the fact that techniques are available todefend against a hostile takeover.


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` The shareholders / owners have to incur 4 types ofcosts:

Monitoring

Bonding

OpportunityStructuring


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` Such expenditures relate to monitoring the

activities of the management to prevent a

satisfying behavior by them.

` The monitoring outlays relate to payment for auditand control procedures to ensure that managerial

behavior is tuned to actions that tend to be in best

interest of the shareholders.


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` They protect the owners against the potential

consequences of dishonest acts by management/

mangers.

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

party bonding company to the effect that the latter will

compensate the former up to a specified amount for

financial losses caused by dishonest acts of managers.


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` Such costs result from inability of large corporate

from responding to new opportunities.

` Due to the organizational structure , decision

hierarchy and control mechanism , the

management may face difficulties upon profitable

investment opportunities quickly.


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` They relate to structuring managerial compensation to

correspond with share price maximization.

` The objective is to offer incentives to management to

act in the best interest of the shareholders.

` The restructured higher compensation packages to

managers also enable corporate to hire the best available

managers.


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` Fall into two groups:A) Incentive plans

B) Performance plans

A) Incentive plans :They tie management compensation

to share price .Most widely used incentive plan is

stock options which confer on management the

right to acquire shares of the corporate at a

special concessional price.

.A high future price would result in larger management

compensation.


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` These plans compensate management on the basis of itsproven performance measured by EPS, growth in EPS

and other ratios related to return.

` Based on these ,performance shares may be given to

management for meeting the stated performance goals.` Another form of performance based compensation is

cash bonuses that is, cash payments tied to the

achievement of certain performance goals.

Agency relationships & costs

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