Agency Cost in Corporate Finance

Agency costs mainly arise due to divergence of control, separation of ownership and control and the different objectives rather than shareholder maximization the managers consider. According to Ross and Westerfield, when a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm. These strategies may be incentive to take large risks, incentive toward underinvestment, milking the property. There are various factors in the field and various objectives that can incur costly correctional behavior. The various factors are mentioned and their objectives are given below: Management: Management, specifically the CEO, have their objectives to pursue. The classical ones are empire-building, risk-averse investments and manipulating financial figures to optimize bonuses and stock-price-related options. The latter may be just outright fraudulent, but the first two certainly aren't. They erode stockholder value, but a riskaverse strategy is not by definition fraudulent. Bondholders: Bondholders typically value a risk-averse strategy since that will increase the chances of getting their investment back. Stockholders on the other hand are willing to take on very risky projects. If the risky projects succeed they will get all of the profits themselves, whereas if the projects fail the risk is shared with the bondholder. Bondholders know this of course, so they will have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects should they arise, or they will simply raise the interest rate which in turn increases the cost of capital for the company. Board of Directors: The board of directors in the literature is typically viewed as aligned with either management or with stockholders, but recent theory suggests that they too have own

objectives. A very easy non-executive director is valuable to the CEO who gets more leeway, but a very critical non-executive director may be just as valuable to the stockholders. Directors further don't want to be the only ones who are critical towards the CEO, because that increases their chances of being removed from the board. The behavior of directors is not well known and the theory is largely scarce on this matter. Labor: Labor is sometimes aligned with stockholders and sometimes with management. They too share the same risk averse strategy, since they cannot diversify their labor whereas the stockholders can diversify their stake in the equity. Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On the other hand, if the CEO is clearly underperforming the company is in threat of a hostile takeover which typically leads to job-loss as well. They are therefore likely to give the CEO considerable leeway in taking risk adverse projects, but if the manager is clearly underperforming, they will likely signal that to the stockholders. Other Stakeholders: Other stakeholders such as government, suppliers and customers all have their specific interests to look after and that might incur additional costs. The literature however mainly focuses on the above categories of agency costs.

Reasons for Agency Cost

The agency cost arise when somebody (the principal) hires somebody else (the agent) to carry out a task and the interests of the agent conflict with the interests of the principal. An example of such principal-agent problems comes from the relationship between the shareholders who own a public company and the managers who run it. The owners would like managers to run the firm in ways that maximize the value of their shares, whereas the managers prior ity may be say to build a business empire through rapid expansion and merger and acquisitions, which may not increase their firm's share price. The principal-agent problem deals with a lack of symmetry between the desires of the agent and the principal. Principal-agent problem is usually between the

shareholders of a company and the agents that run the company (CEO and other executives). When the executives do things that are in their own best interests and not to the benefit of shareholders, then there is an agency problem in the company. One way to reduce agency costs is for the principal to monitor what the agent does to make sure it is what he has been hired to do. But this can be costly, too. It may be impossible to define the agent's job in a way that can be monitored effectively. For instance, it is hard to know whether a manager who has expanded a firm through an acquisition that reduced its share price was pursuing his own empire-building interests or say was trying to maximize shareholder value but was unlucky. Another way to lower agency costs, especially when monitoring is too expensive or too difficult, is to make the interests of the agent more like those of the principal. For instance, an increasingly common solution to the agency costs arising from the separation of ownership and management of public companies is to pay managers partly with shares and share options in the company. This gives the managers a powerful incentive to act in the interests of the owners by maximizing shareholder value. But even this is not a perfect solution. Some managers with lots of share options have engaged in accounting fraud in order to increase the value of those options long enough for them to cash some of them in, but to the detriment of their firm and its other shareholders. See, for example, ENRON.

Monitoring Agency Costs

Agency cost can be reduced in two ways: by monitoring the managers effort and actions and by giving them the right incentives to maximize value. Monitoring can prevent the most obvious agency cost such as blatant perks. It can confirm that the manager is putting sufficient time on the job, but it requires time and money. Some monitoring is almost always worthwhile, but a limit is soon reached at which an extra rupee spent on monitoring would not return an extra rupee of value from reduced agency cost. Some agency cost cannot be prevented even with spendthrift monitoring. For example, a

shareholder undertakes to monitor capital investment decision. How could he or she ever know

for sure whether a capital budget approved by top management or not. Monitoring is the shareholders responsibility, but in large public companies monitoring is delegated to the board of directors, who are elected by shareholders and are suppose to represent their interest. The board also hires independent accountants to audit the firms financial statements. If the audit uncovers more problems, the auditors issue an opinion that the financial statements fairly represents the companys financial condition and are consistent with generally accepted accounting principles. If problems are found, the auditors will negotiate changes in assumptions or procedures. Managers almost always agree because if acceptable changes are not made, the auditors will issue a qualified opinion, which is bad news for the company and shareholders. A qualified opinion suggests that managers are covering something up and undermines investors confidence that they can monitor effectively. In a company, lenders also monitor. If a company takes out a large bank loan, the bank will track the companys assets, earnings, and cash flow. By monitoring to protect its loan, the bank protects shareholders interest also. Delegated monitoring is especially important when

ownership is widely dispersed. If there is a dominant shareholder, he or she will generally keep a close eye on top management. But when the number of stockholders is large and its

stockholding is less, individual investors cannot justify much time at expenses for monitoring. Each is tempted to leave the task to others, taking a free ride on others efforts. But if everybody prefers to let somebody else do it, then it will not get down, i.e., monitoring by shareholders will not be strong or effective. Economists call this free rider problem. If this problem is severe, delegated monitoring may be the only solution. But delegation brings its own agency problems. For example, many board members may be longstanding friends of the CEO and may be indebted to the CEO for help or advice. Understandably, they may be reluctant to fire the CEO or enquiry too deeply into his or her conduct. Auditing firms may also have conflicts of interest. For example, many believed that Enrons auditor, Arthur Andersen, might have been tougher on the company had it not also earned substantial fees from providing Enron with consulting services. As a result, auditing firms are no longer allowed to provide both auditing and

consulting services to the same company.