AGENCY THEORY

Introduction:
Agency theory provides the framework for
discussing the relationships that exist between
the various interest groups in an organization.
It views the firm as a “composite unit” consisting
of separate interest groups.
Each interest group pursues its own interest and
ensures it stands at an advantageous position in
relation to the firm.
Each individual group however recognizes the
fact that its success is a function of the company
vis-à-vis other companies in the same industry.
Agency theory:
The theory brings out a clear exposition of
the actions of some managers which are
not in consonance with the actions they
were to take, assuming shareholder’s
wealth maximization objective is pursued.
Agency Relationship:
Agency relationship exists when one person
(or a group of persons) called the Principal,
appoints another person called the Agent to
perform some work on its behalf and gives
the agent the appropriate decision-making
authority.
In the context of Strategic Financial
Management, such relationships occur,
among others between:
 Shareholder’s and managers; and
 Creditors and shareholders
Agency Relationship:
It is natural that where such relationship
exists, there is bound to be conflict of
interest which creates a problem known as
agency problem.
The reason underlining the conflict in the
case of shareholders-managers
relationship is the separation of ownership
and control.
Shareholders vs Managers
Conflict due to separation of ownership
and control may arise in the following
situations:
Choice of Projects Appraisal Technique

In pursuit of their self-interests,

managers may prefer projects with short
lives against those with long lives. They
may therefore want to use Payback
technique instead of the superior Net
Present Value technique.
Shareholders vs Managers
Appraisal of Risky Projects: Financial
managers may not want to undertake
projects which bring substantial benefits
to the owners, but are highly risky,
because of the negative impact of this risk
on their own financial position. However,
this risk has presumably been well
diversified away by the shareholders.
Shareholders vs Managers
Gearing: Financial managers may not want
the company’s debt to be unduly large in
relation to equities so as to reduce the
financial risk of the company. Financial
managers may however, by doing this, not
be taking advantage of tax-deductible
interest cost, where interest is treated by
the tax authorities as a charge against
profits.
Shareholders vs Managers
Takeover bids: When a company is
compulsorily taking over another
company, the target company’s directors
may be resisting such action in order to
protect their own jobs; even though it will
bring greater wealth to the existing
shareholders.
Shareholders vs Managers
Leveraged Buy-Out: In a leveraged buy-
out, the company’s management borrows
funds to purchase the outstanding shares
of the company via a tender offer (an offer
to buy the shares of a company directly
from the shareholders). There is the
possibility that managers might try to
drive down the price of the company’s
share just before the tender offer, so that
they can buy the shares at a bargain price.
Shareholders vs Managers
Dividend Policy: This is where financial
managers are pursuing an unduly
conservative dividend policy: that is,
trying to keep dividends at a level which is
much lower than the normal level, given
the industry norms. The question ,
however, is: can the funds not distributed
be utilized better by the shareholders
themselves, if received as dividends?
Shareholders vs Managers
Disclosure of Information in the Financial
Statements: This is where financial managers
“paint” the financial condition of the company via
its balance sheet , rosier than what it really is.
This is known as “window dressing” or, in a mild
form, “creative accounting”. It is made possible by
the open-ended nature of the choice of accounting
policies, when directors prepare financial
statements. For example, directors might want to
defer certain type of expenditure (e.g. advertising)
and capitalize it or put value on intangibles such
as patents.
Shareholders vs Managers
Ethics: Top management might display certain
unethical practices when it makes some
decisions on operations. Typical examples of
such practices are the degradation of the
environment through pollution and testing of
products on human beings.
Shareholders vs. Managers
Possible solutions :
 Shareholders need to ensure that there is
“Goal congruence”.
 Goal congruence means convergence of the
interests of different groups such that the
overall goal of the company can be achieved.
 It means the need for shareholders to ensure
that managers take actions in accordance
with their expectations and in their best
interest.
Possible solutions:
The actions necessary to achieve goal
congruence are as follows:
 Monitoring: The company needs to monitor
every action of management. However, some costs
known as agency costs would be incurred. This is
an expensive way of ensuring goal congruence.
Agency costs would include expenditure that is
necessary to physically monitor the manager and
expenditure to restructure the organization so
that bad elements within the system are removed.
 They also include opportunity costs arising from
profits lost when managers take decisions as
agents instead of as owner-managers.
Possible solutions:
Compensation via allocation of shares
in the company: In this case costs might
not be too prohibitive as managers would
gear their efforts toward profitability and
capital appreciation via cutting down
operational costs including salaries and
bonuses and taking less time off duty.
Possible solutions:
Threat to Dismissal: This may not be
effective as ownership in many big
companies (where ownership and control
are highly separated) is widely dispersed
and shareholders often find it difficult to
speak with one voice. Few shareholders
attend the annual general meetings and, in
any case, directors usually ensure they get
enough proxies to support them at meetings.
It should be noted however, that the
presence of institutional investors could
weaken the directors strength.
Possible solutions:
Exposure to Take-over Bid: This could
deter managers from taking actions that will
be at variance with share price
maximization. If the company’s earning
potentials are being knowingly or
unknowingly suppressed through bad
policies and the share is consequently
undervalued, in relation to its value, it may
be exposed to Take-over. The result is that
some top managers might lose their jobs and
the authorities of those remaining might be
drastically reduced.
Possible solutions:
Executive Share Option Scheme: This is a
performance-based scheme that allows top
managers to buy the shares of the company
in future, at a price determined now. The
belief is that this will motivate the managers
to continually take actions that will be
pushing up the share price: the option has
value if the price of the share increases
above the originally fixed option purchase
price. It should be noted, however that this
scheme may not be beneficial to managers in
a period of market downturn.
Possible solutions:
Performance Shares: These are shares
given to top managers and linked to
company’s performance as mirrored by its
fundamentals – earnings per share, return
on capital employed, return on equity,
dividend per share and so on. This scheme
is valuable to the extent that it is not
affected by changes in the stock market.
The agency problem of creditors and
shareholders:
 Capital Investments: Creditors would not
like a situation where the acceptance of a
project will add greater business risk than is
expected by them. If this happens, they will
increase their required rate of return and the
value of their outstanding debt will fall. The
major concern of creditors here is that if risky
project succeeds, creditors will only receive a
fixed amount (interest income) and
shareholders will take all the benefits’
whereas, if the project fails, they will share the
losses with the owners.
The agency problem of creditors and
shareholders:
Gearing: Where the company increases its
gearing (debt/equity) ratio to a level that
increases financial risk to more than
expected, the value of the existing debt will
fall because the earnings and assets
backing available for this debt will diminish
as a result of the new issue of debt.