Agency Costs and Financial Decision-Making

Agency Costs and Financial Decision-Making The Concept An authorization relationship is a contr solve under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship atomic number 18 value maximizers and they may lead divergent goals and objectives, and thither is good reason to believe that the agent will not al modes act in the surmount interests of the principal (Jensen, Michael C. , and William H.Meckling. Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure. journal of Financial Economics 3 (October 1976), 305-360) The concept of agency cost recognizes there atomic number 18 fundamental differences in how shareholders, managers, and even bondholders interpret their respective relationships to an organization. While they may share some uncouth goals and objectives, there is the p otential for at least(prenominal) some objectives to emerge that are focused more on individual enrichment than on the well-being of the whole.For example, managers may be more focused on mental synthesis a reputation for themselves, possibly creating their bear power bases within the structure of the larger organizations. Shareholders may become more focused on earning dividends now and slight on the future of the business. Bondholders may be concerned only with the project associated with the bond issue, and lose sight of how the overall stability of the company potentiometer give way a negative impact on the transcend earned from that bond. ( http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. tmlixzz14WVaUW4g) Agency Costs is an economic concept which is defined as the cost dumbfoundred by an entity in relation to issues like varied goals and objectives of the trouble and shareholders and information asymmetry. Self-Interested Behavior Agency theory su ggests that, in imperfect labor and capital markets, managers will examine to maximize their own utility at the expense of corporate shareholders. Agents have the ability to operate in their own self-interest rather than in the best interests of the firm because of asymmetric information (e. g. , managers know better than shareholders whether they are apable of meeting the shareholders objectives) and uncertainty (e. g. , myriad factors contri thoe to final outcomes, and it may not be seeming(a) whether the agent directly caused a given outcome, positive or negative). Evidence of self-interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal risk positions, whereby risk-averse managers bypass profitable opportunities in which the firms shareholders would prefer they invest. Outside investors recognize that the firm will make decisions contrary to their best interests.Accordingly, investors will enta ilment the prices they are willing to pay for the firms securities. (Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and Incentives. Berlin Springer-Verlag, 1987). A potential agency conflict arises whenever the manager of a firm owns less than 100 percentage of the firms super acid stock. If a firm is a sole proprietorship managed by the owner, the owner-manager will undertake actions to maximize his or her own welfare. The owner-manager will probably measure utility by personal wealth, but may trade off other considerations, such as leisure and perquisites, against personal wealth.If the owner-manager forgoes a portion of his or her self-possession by selling some of the firms stock to outside investors, a potential conflict of interest, called an agency conflict, arises. For example, the owner-manager may prefer a more leisurely lifestyle and not work as vigorously to maximize shareholder wealth, because less of the wealth will now accrue to the owner-m anager. In gain, the owner-manager may decide to conduct more perquisites, because some of the cost of the consumption of benefits will now be borne by the outside shareholders. Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and Incentives. Berlin Springer-Verlag, 1987. ) In the majority of large publicly traded corporations, agency conflicts are potentially quite significant because the firms managers generally own only a small percentage of the common stock. thitherfore, shareholder wealth maximization could be subordinated to an assortment of other managerial goals. For instance, managers may have a fundamental objective of maximizing the size of the firm.By creating a large, rapidly growing firm, executives increase their own status, create more opportunities for lower- and middle-level managers and salaries, and enhance their job security because an unfriendly takeover is less likely. As a result, incumbent management may survey diversification at the expense of the shareholders who can easily diversify their individual portfolios simply by buying shares in other companies. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) Managers can be hiked to act in the stockholders best interests through incentives, constraints, and punishments.These methods, however, are effective only if shareholders can observe all of the actions taken by managers. A moral hazard problem, whereby agents take unobserved actions in their own self-interests, originates because it is infeasible for shareholders to monitor all managerial actions. To reduce the moral hazard problem, stockholders must incur agency cost. Measuring Agency Costs The idea behind assessing agency cost is to attempt to identify what impact these differences in objectives and the flow of information between the agent or manager and the shareholders is having on the overall profitability of the organization.By correctly identifying and addressi ng issues of agency cost, it is possible to minimize the influence of those factors, at least enough to lease the organization to continue moving forward, rather than running the risk of failure. Determining the agency cost normally begins with looking closely at the potential costs or risks associated with including some type of agent or manager in the organizational structure. For example, one potential risk would be the possibility that the individual who is constitute as an officer in the company could seek to use company assets for his or her own personal gain, to the detriment of the company.At the same time, agency cost withal looks at the expense involved in anticipating potential abuses of power and resources, and structuring the organization so that abuse is less likely to occur. This may include offering incentives to notice employees that promote loyalty and lessen the chance of misappropriation of resources, or structuring the accounting process so that a series of checks and balances create a separation of control, in effect preventing any one individual from having too much power within the organization. http//www. wisegeek. com/what-is-an-agency-cost. htm) Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. The notion of agency costs is perhaps most associated with a seminal 1976 Journal of Finance paper by Michael Jensen and William Meckling, who suggested that corporate debt levels and management equity levels are both influenced by a wish to contain agency costs. There are three major types of agency costs 1) Expenditures to monitor managerial activities, such as audit costs (2) 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 companys business units and management hierarchy (3) 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.In the absence of efforts by shareholders to alter managerial behavior, there will typically be some loss of shareholder wealth due to inappropriate managerial actions. On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed with shareholder interests. Therefore, the optimal amount of agency costs to be borne by shareholders is determined in a cost-benefit contextagency costs should be increased as long as each incremental dollar spent results in at least a dollar increase in shareholder wealth. (http//www. referenceforbusiness. om/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) Financial decision making for dealing with agency costs There are two polar positions for dealing with shareholder-manager agency conflict s. At one extreme, the firms managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firms earnings would be affected by economic events that are not under managerial control.At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive compensation is tied to achievement, but some monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders interests (1) performance-based incentive plans (2) direct intervention by shareholders (3) the threat of firing (4) the threat of takeoverMost publicly traded firms now employ performance shares, which are shares of stock gi ven to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firms managers earn more shares. If performance is below the target, however, they receive less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives.First, they offer executives incentives to take actions that will enhance shareholder wealth. Second, these plans help companies force and retain managers who have the confidence to risk their financial future on their own abilitieswhich should lead to better performance. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) An increasing percentage of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds.The institu tional money managers have the clout, if they choose, to exert considerable influence over a firms operations. Institutional investors can influence a firms managers in two primary ways. First, they can meet with a firms management and offer suggestions regarding the firms operations. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders meeting, even if the proposal is opposed by management.Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) In the past, the likelihood of a large companys management being ousted by its stockholders was so remote that it posed little threat. This was true because the ownership of most firms was so widely distributed, and