Agency Theory

This theory actually caters with the problems arising among principle and agents. This theory looks at the conflicts arising among principles and agents. Principle and agent; these two factors make an agency in which one is acting on behalf of other or representing the other.

In a company principle agent relationship exists between Shareholders (Principles) and management (Agents). Shareholders are the owners of the company who invest their capital. They directly or indirectly hire management to run the affairs of the business. They expect them to carry out the business in favor of shareholders and generate maximum profits. So management have obligation to run all affairs of the company using their knowledge, skills and abilities and honestly. Managers are custodian of shareholders’ interest.

But sometimes there may be a situation when interests of shareholders and agents differ. And this variance in interest creates problems. This is called Agency Problem. Shareholders may suffer because of certain decisions of the management which are in favor of managers. Managers are majorly concerned about their monetary benefits, rank, position and rooting in the company so they may hide some material facts which are the consequence in guarding their own interests. For example, CEO may want to increase its managerial empire and personal stature and use funds to finance unrelated diversification.
This could reduce shareholders’ value.

Agency theory deals with these problems and tries to provide best possible way to eliminate it. But in efforts to eliminate these problems, certain cost of the principle is inflicted or expenses incurred in order to sustain an effective agency relationship; this is called as agency cost. Following are the costs of shareholder-management conflict:

• expenditures to monitor managerial activities, such as audit costs;

• expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside members to the board of directors or restructuring the company's business units and management hierarchy;

• 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.

Following are the ways to reduce the agency costs:

• Incentive schemes for managers to reward them financially for maximizing owners’ interest
– e.g. shares at reduced price, thus aligning financial interests of executives with those of share holders
• direct intervention by shareholders
• the threat of firing
• the threat of firing


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