FINANCIAL MANAGEMENT II MOUNT KENYA UNIVERSITY (MKU) NOTES PDF

AGENCY THEORY

1.1 Introduction

Agency refers to the relationship which submits between two parties, one party called the principal engages another one called agent and gives agent authority and mandate to act on the principal’s benefit.
The actions of agent are binding on the principal. In finance, stockholders are owners of the firm and are therefore the principal. However, they are not involved on the management of running of the firm for a number of reasons.

  • They may not have the necessary skills and expenditure of managing the firm.
  • They may not have them to run the firm.
  • They may be geographically dispersed to manage the firm.
  • They may be too many to manage a single firm.

Therefore enjoy management directors who ask on their behalf the directors are the Agents. They are given capital authority and other resources for use or that they can generate profits on behalf of principle stakeholders.
The concept of entrusting resources with individuals where they are expected to give an account of how the resources are used is called stewardship. The directors/top management are required to combine the where they have utilized he resources entrusted. Usually a conflict of interest arises when the agents pursue their own interest at the expense of the stockholders.

1.2 Types of Agency relationships

  • Shareholders versus Management
  • Shareholders versus Long-term Creditors
  • Shareholders versus Auditors
  • Shareholders versus Government
  • Shareholders versus Branches

1.2.1 Shareholders versus Management

The management of a firm take some actions which are inconsistent with the goal of shareholders of wealth maximization and this will cause a conflict of interest.
The various causes of this conflict include the following:

  • Incentive Problem

    Top managers have a fixed salary and may not have the incentive/motivation to work harder in order to maximize the shareholders wealth. This is because, irrespective of the benefit they make, their records is fixed they will therefore maximize on leisure’s and work less. This will be against the interest of the shareholders hence the conflict.

  • Consumption of perks/perquisites

    Perquisites refer to the high salaries and generous fringe benefits which directors’ award themselves. This will take the form of directors’ remuneration, expensive cars, expensive holidays, expensive assistance, post office etc. all these will constitute an expense to the company and will therefore reduce the amount of dividend paid to ordinary shareholders and who are the true owners of the company. Therefore, the consumption of perks directors is against the interest of shareholders as it reduces their wealth.

  • Differences in Risk Profile
    Shareholders prefer high risk; high return projects since they have diversified investments that is, if one firm or project one collapses it will have an insignificant effect on their overall wealth. Managers on the other hand, will prefer low return investment since they have a personal fear of losing their jobs in case of a given project/company collapsing. This is because managers do not have multiple jobs and can therefore not be diversified. This forces them to strive for returns for shareholders and not necessarily the maximum. This difference is risk profile is therefore a source of conflict.
  • Difference in Investment/Evaluation Horizon
    Managers prefer to undertake profit which are profitable in the short-term so that they can take credit when they are still in the company shareholders. On the other hand, prefer long-term investment which is consistent with the going concern concept of the firm. A conflict will therefore occur since directors will undertake short term investment against shareholders’ desire for long term investment projects.
  • Management Buyout
    The management may attempt to acquire the business of the principal (shareholders). They would do this forming nominees companies who buy the shares of the company at the stock exchange. Once they get a majority shareholding. This is equivalent of staging a coup and taking over the business of the shareholders. This causes conflict between agency and principal.

Solutions to the preceding type of agency problem

  • Compensation plans
  • Board of Directors
  • Takeovers
  • Specialist Monitoring
  • Auditors

 

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