AGENCY PROBLEM

Module-I

AGENCY PROBLEM

Agency problem is the likelihood that managers may

place personal goals ahead of corporate goals.

The Principal-Agent Relationship

The Agent is the person that acts, whereas the
Principal is the person that receives the benefits from
the actions.
An agency relationship occurs when a principal hires
an agent to perform some duty.

AGENCY PROBLEM
A conflict, known as an "agency problem," arises

when there is a conflict of interest between the

needs of the principal and the needs of the agent.

The Agency Problem tries to solve the natural conflict

of interest that arises as a result of this principal
agent problem

The dilemma exists because sometimes the agent is

motivated to act in his own best interests rather than
those of the principal.

Agency Relationships
In finance, there are two primary
agency relationships:
Managers and stockholders
Managers and creditors

Agency Costs
These are costs incurred in an attempt
to push agents to act in the principals
best interest.
It consist of three types:

Direct contracting costs

Monitoring costs
Loss of principals wealth due to residual,

unresolved agency problems.

Prevention of Agency
Problem
The

agency problem can be

prevented by:
Market Forces
Agency Costs

Market Forces:
It is of two types:
Behaviour of security market participants
Hostile Takeovers

Contd.
Behaviour of security market participants:
The participants include institutional investors(mutual

funds, insurance etc.) actively participate in management.

They use their voting rights to replace more competent
management.

Hostile takeovers:
It is the acquisition of the firm by another firm that is not

supported by management. The constant threat of

takeover motivate management to work for maximising
owners wealth.

AGENCY COST

These are the costs borne by shareholders to

prevent agency problem as to maximise owners
wealth.

They have to incur 4 types of costs:

Monitoring
Bonding
Opportunity
Structuring

Monitoring Expenditures and

Bonding Expenditures
Monitoring the activities of the management to
prevent satisfying and maximising owner wealth.
It relates to the payment for audit and control
procedures to ensure that management is
working for maximising owners wealth.
Bonding protects the owners from the
consequences of dishonest acts by
management/managers.
The firm pays to obtain a fidelity bond from a
third party bonding company to compensate for
financials loses due to dishonest acts.

Opportunity cost and

Structuring expenditure
Opportunity costs are those which results from
the inability of the firm to respond to new
opportunities.

Due to organisational structure, hierarchy etc.

the management faces difficulties in seizing
profitable investment opportunities.

Structuring expenditure relates to structuring

managerial compensation to maximise owners
wealth.

Contd

2.

It is of two types:
Incentive Plans
Performance Plans

Incentive Plans:

They tie management compensation to share price.

The most widely used plan is stock options which

allows management to acquire shares at special
prices. Higher price will result in larger management
compensation.

1.

Contd.
Performance Plans:

These plans compensate management on the

basis of its proven performances.

Performance shares are given to management for

meeting the stated goals.

Another type, cash bonuses cash payments are

given for achievement of the stated performance
goals.

Thank you...!!