10.

1 INTRODUCTION

(1976). They suggested

Agency theory was developed by
Jensen and Meckling
is based on the conflicts of interest
of how the governance of a company
theory
and major providers of
a

between the company's owners (shareholders), its managers

The
these has different interests and objectives.
debt finance. Each of groups
the returns
want to increase their income and wealth. Their interest is with
shareholders
of their
that the company will provide in the form of dividends, and also in the value
shareholders.
shares, The managers are employed to run the company on behalf ofthe
However, if the managers do not shares in the company, they have no direct
own
interest in future returns for shareholders, or in the value of the shares and the major
providers of debt have an interest in sound financial management by the company'sS
managers, so that the company will be able to pay its debts in full and on time.

Jensen and Meckling defined the agency relationship as a form of contract

between a company's owners and its managers, where the owners (as principal)
appoint an agent (the managers) to manage the company on their behalf Agency

- theory suggests that the prime role of the board is to ensure that executive behaviour
is aligned with the interests of the shareholder-owners) Otherwise, self-interested
managers will use their superior information to line their own pockets.

10.2 OBJECTIVE

After going through this lesson, you should be able to learn about

agency theory
agency cost

agency conflicts and

psychological influences.
10.3 AGENCY THEORY

Agency theory is a principle that is used to explain and resolve issues in the
relationship between business principals and their agents. Most
commonly,
relationship is the one between shareholders, as principals, and company
that
executive,
as agents. Agency Theory is a
management and economic theory that explains the
various relationships and areas of self-interest in companies. Put another way,
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agency theory describes the
the delegation of control.
relationship between principals and agents as weil as

Roger G. Schroeder, M. Johnny Rungtusanatham and Susan

in their 2011 article, Meyer Golstein.
"Operations Management in the Supply Chain: Decisions and
Cases" stated that
Agency theory also explains how best to organize relationships in
which one party, called the
"principal," determines the work and in which another
party, known as the "agent," performs or makes decisions on behalf of the principal
in proprietorships, partnerships, and cooperative societies, owners are actively
involved in management. But in companies, particularly large public imited
companies, owners typically are not active managers. Instead, they entrust this
responsibility to professional managers who may have little or no equity stake in
the firm. There are several reasons for the separation of ownership and management
in such companies:

Most enterprises require large sums of capital to achieve economies of

scale. Hence it becomes necessary to pool capital from thousands or
even hundreds of thousands of owners. It is impractical for many
owners to participate actively in management.

Professional managers may be more qualified to run the business because

of their technical expertise, experience, and personality traits.

Separation of ownership and management permits unrestricted change

in owners through share transfers without affecting the operations of
the firm. It ensures that the 'know-how' of the firm is not impaired,
despite changes in ownership.

Given economic uncertainties, investors would like to hold a diversified

portfolio of securities. Such diversification is achievable only when
ownership and management are separated.

While there are compelling reasons for separation of ownership and

management, a separated structure leads to a possible conflict of interest between
managers (agents) and shareholders (principals). Though managers are the agents of
shareholders, they are likely to act in ways that may not maximise the welfare of
shareholders.
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 hence have a natural
enjoy substantial autonomy and
In practice, managers
from getting dislodged from their
nclination to pursue their own goals. To prevent
to achieve a certain acceptable
level of performance as
position, nmanagers may try
that their personal goals
far as shareholder welfare is concerned. However, beyond
their
like presiding over a big empire, pursuing their pet projects, diminishing
tend to
personal risks, and enjoying generous compensation and lavish perquisites
acquire priority over shareholder welfare.

Agency theory assumes that the interests of a principal and an agent are not
always in alignment. The lack of perfect alignment between the interests of managers
and shareholders results in agency costs which may be defined as the difference
between the value of an actual firm and value of a hypothetical firm in which
management and shareholder interests are perfectly aligned.
To
mitigate the agency problem, effective monitoring has to be done and
appropriate incentives have to be offered. Monitoring may be done by
bonding
managers, by auditing financial statements, by limiting
certain managerial discretion in
areas, by reviewing the actions and performance of
and so on. managers periodically,
Incentives may be offered in the form of cash
bonuses and perquisites that
are linked to certain
performance targets, stock options that grant
right to purchase equity shares managers the
at a certain price, thereby
ownership, performance shares
giving them a stake in
given when certain goals are achieved, and so on.
The design of
optimal compensation contract depends several factorson
such as the extent to which the actions
ofmanagers
informational asymmetry between
are
observable, the degree of
managers and shareholders, the differences in
the time horizons of and
managers shareholders, the differences in the
of managers and risk tolerance
shareholders, and the adequacy of
performance metrics.
Good corporate
governance, including
isimportant for maximising the value of the optimal compensation contract design,
firm and
capital in the economy. optimising the allocation of
10.3.1 Special Considerations in
Agency Theory
Agency theory addresses disputes that arise
difference in goals or a
differenee
primarily
in risk aversion.
in two
key areas: A

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 For
example, company executives may decide to
markets. This will sacrifice the expand a business into new
short-term profitability of the company in the
expectation of growth and
higher earnings in the future. However, shareholders
may place priority on short-term
a
capital growth and oppose the company decision.
Another central issue often addressed by
agency theory involves incompatible
levels of risk tolerance between a
principal and an agent. For example, shareholders
in a bank may object that management has set the bar too low loan
on approvals,
thus taking on too great a risk of defaults.

10.3.1.1 Ageney Costs

Agency costs refer to the conflicts between shareholders and their company's
managers. Suppose a shareholder, a principal, wants the manager, the agent, to
make decisions that will increase the share value. Managers, instead, would prefer
to expand the business and increase their salaries, which may not necessarily
increase share value. In a publicly held company, agency costs occur when a
company's management, or agent, place their own personal financial interests above
those of the shareholder or principal.

Agency costs can be either:

i. Those incurred if the agent uses the company's resources for his own
benefit.

ii. The cost of techniques that principals use to prevent the agent from

prioritizing his interests over shareholders' interests.

To prevent the agent from acting to bencfit himself, shareholders, or principals,

may offer financial incentives to keep shareholders' interest as the top priority.
This typicaly means paying bonuses to management if and when share price
increases or by making the management's salary partial shares in the company"
Such incentives are an example of agency costs. If the incentive plan works, these
agency costs will be lower than the cost of allowing the management to act in their

Own interests.

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 Agency costs are important because although they are difficult for an account
to track, thcy are just as difficult to avoid. This is because principals and agents
can have very different motivations.

10.3.1.2 Agency Conflicts

Implied in the fact that agents and principals have very different motivations,
is the fact that conflicts can easily arise because of those differing goals. These
causes of agency problems can arise because of differences between the goals or
desires between the principal
and the agent. Put another way, agency problems
arise because of the inherent conflict of interests between
agents and principals.
Agency theory assumes both the and the agent are motivated by
principal
self-interest. This assumption of self-interest dooms
agency theory to inevitable
inherent conflicts. Thus, if both parties are motivated
by self-interest, agents are
likely to pursue self-interested objectives that deviate and even conflict with the
goals of the principal"

Agency problems, also known as

"principal-agent problems or
asymmetric
information-driven conflicts of interest," are inherent in
corporate structures. This
conflict arises when separate parties in a business
relationship, such as a corporation's
managers and sharcholders, or principals and agents, have disparate interests. Principals
hire agents to represent principals'
and
interests.Agents, working as employees, are assumed
obligated to serve the principal's best interests. Problems occur when the agent
begins serving different interests, such as the agent's own interests. Thus, conflict
occurs between the interests of principals and agents when each
party has different
motivations, or incentives exist that place the two parties at odds with each other.
10.3.2 Resolving Agency Conflicts
Companies use several methods to avoid
agency conflicts, including
monitoring, contractual incentives, soliciting the aid of third parties or relying on
other price systems.

1. Creating incentives for employees: If agents are acting in their own

interests, changing incentives to redirect these interests may be beneficial
for principals. "For
example, establishing incentives for achieving sales
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 quotas may result in more sales people recaching daily sales goals. If
the only incentive available to sales
people is hourly pay, employees
may have an incentive discouraging sales". Companies would do well
to create incentives that encourage hard work on projects that benefit
the company. This will motivate more employees to act in the busines's
best interest. By aligning agent and principal goals, agency theory
attempts to bridge the divide between employces and employers created
by the principal-agent problem.
2. Using standard principal-agent models: Financial theorists, corporate
analysts and economists create principal-agent models to spot and
minimize costs. For example, most agency experts try to design
contracts that can align the incentives of both parties- the agent(s) and
principal(s) - in a more efficient manner. Unfortunately, such contracts

result in unintended consequences. Using a much-used cliche, the

principal-agent model secks to help companies and investors create a
win-win situation.

3. Using agency theory, itself: Agency theorists use written contracts and
monitoring, to avoid agency problems. For example, Apple Inc. in 2013
began requiring senior executive employces and board of directors
members to own stock in the company. This move wasintended to align
executive interests with those of shareholders as management was no
longer benefited from actions that harm shareholders because members of
management were themselves, investors. As in the principal-agent models,
Apple sought to create a win-win situation for principals and
agents.
4. Using the market for corporate control: The most frequent example
of market discipline for corporate managers is the hostile takeover, in
which bad managers damage shareholders' interests
by failing to realize
a
corporation's potential value. The solution is to provide an incentive
for better management to take over and
improve operations. Even
better: Giving new management a stake in the
company, through equity
shares for example, would help align the interest
of
agents, and the investors, the principals. management, the
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