The agency problem is the interest conflict innate in any relation wherever it is expected by one people to perform in the best interest of others. In corporate finance, the agency problem usually means the interest conflict between the manager of firm and stakeholders of the company. The manager of firm, performing as an agent for the shareholders, or principals is expected to take decision which will maximize shareholder’s wealth even though it is in the best interest of managers to enhance the personal wealth (ElKelish, 2018).
An agency relationship exists between the management or agent and the principal or owner or capital providers of the firm. If the agent and principle, both are wealth maximisers then the chances of conflict increases. The agent may take step to increase their own wealth, and this step cannot essentially be in best interest of principal. In the case where, there is the variance between aims management followed and then of holder, it can be inferred that the agency problem exists. This aspect is examined in the practical section of the learning (Neal and Warren, 2015).
There are various illustrations of the cost or action by the management that may give rise to excessive or avoidable cost which curtails the condition of conflicts-
The agency problem arises due to an issue with incentives and the presence of decision in the achievement of task. The agent can be encouraged to perform in the way that is not favourable for the principal, such as the situation when the agent is presented with the incentive to perform in proper manner. One popular example of agency problem is that of Enron. In the matter of Ponzi Schemes, agency problem may have legal concerns and economic concerns for financiers and agents. Enron’s BOD failed to carry the supervisory role in corporation and disallowed the inaccurate obligations, causing the corporation to venture in prohibited activities. The management team and BOD do not have similar interest as stakeholders. It was legal obligation of directors of Enron to secure and encourage interest of financiers however other incentives are used for this. The absence of arrangement between the stakeholders and boards may be the last resort of demise for Enron.
Agency problem is general in the fiduciary relationship, like between the trustee and beneficiary; members of board and stockholders; solicitors and customers. The relationship can be strict in a legal meaning, as is the case of the relations between advocates and the customers. It is due to the declaration made by American Supreme Court that a lawyer should perform in whole fairness, faithfulness, and reliability towards their customers. Certainly, financial reporting gives useful data in other contracting relations as far as including capital providers such as dealers, clients, auditor, regulator, and relevant tax authorities. People detain the discussion to contracts involving capital providers for the following 3 reasons mentioned below:
(1) These fields are main central points here (Galle and Walker, 2014).
(2) The literature on agency conflicts between managers and capital providers constitutes a natural, interconnected subset of papers that lend themselves to a relatively cohesive discussion, and
(3) It is required to maintain the level of the opinions convenient
The agency cost is the kind of internal cost that the principal can gain as the outcome of an agency problem (Wu, Lan and Liu, 2014). It involves the cost of any inefficiency that can occur from hiring the agents to obtain on the task, in conjunction with the cost connected with supervising or controlling the relation between principal and agent and solving contradictory priorities. Although this is impossible to reduce the agency problem, principals may initiate actions to reduce risks of agency cost. The relation between Principle and agent may be controlled, and frequently arise by the contract or agreement, or rules or law in the case of fiduciary settings. The Fiduciary Rule is the illustration of the effort to control the occurring agency problem in relations between economic advisor and the customers (Tyson, 2018).
Further, the agency problem can also be reduced by incentivizing the agents to perform will lead to an improvement in accordance with the best interest of principal. For an instance, the managers may be encouraged to perform in the best interest of stakeholders by incentives like the compensation on the basis of performance, direct impact by the stakeholders, a fear of firing, or a fear of takeover. The Principals may also modify the framework of the reimbursement of agent. For an instance, in the case when an agent is paid not on hourly basis however by achievement of the assignment, it would result into reduced enticement to not perform in the best interest of principal (Yang and Choi, 2016).
Furthermore, this is the subsistence of the uncertainty in ecological, managerial or job situations, which makes it complicated and costly to assess the performance of other people. The people can have the incentive to perform various because they have different risk preferences or they may have different tendencies to act opportunistically. If any cost is observed in the enterprise, it can be assumed that the agency problem exists. The situation of conflicts between aims does not arise when the owner of an enterprise attends to the management of the enterprise, and consecutively there is no agency problem. The more possession is conferred to the individuals who are not directly included in the administration of the enterprise, thereby increase in the probabilities of conflict. Hence, it is essential to examine the ownership framework of the corporation, which should be done in the practical parts of the learning (Stepanov and Suvorov, 2017).
Moreover, generally the agency theory specifies that the issues present in the corporation with regard to interest of stakeholders: the administration or officials do not always perform in the correct manner. Therefore, leads to an increase in the return of stakeholders on the venture. To resolve this issue, it is important to unite the interests of the managers and stakeholders. The following are 4 mechanisms to encourage manager to perform in the best interest of the stakeholders (Liang and Renneboog, 2018)-
In the present time, the majority of the stock of corporation is owned by big institutional depositors, like pension and the mutual fund. As such, these large institutional stockholders may impact the manger and, as per the requirement the functions of the firm.
When the clients are not happy with the present administration, they may motivate the change the present administration, or shareholders can elect again the new board of directors, which would complete the job (Ni, Chu and Li, 2017).
When the price of stock declines due to incapability of the management to operate the corporation properly, competitors, or shareholders can take the controlling interest in corporation and in the personal manager (Buckalew and Carey, 2015).
The administrative reimbursement must be made not only to keep capable manager, but also to align the interests of managers with the shareholders as much as possible.
As per the above analysis, it can be concluded that the agency problem in firm setting is referring to the conflict in incentive between principal-agent relationships. Occurrence of these issues involve due to the partition between possession and direction. The reason is that it is complex for the principal to review the agents totally, as data asymmetry may increase. It can lead to the occurrence of the doubts in the hand of principal which agent is performing in as personal advantages in place of the benefits of the principal. The agency problem is stated in various manners; for an instance, the phenomenon ethical risk and administrative risk loathing (LUO and WU, 2016). The agency problem is crucial in the business and appears in various capacities. The BOD affects in the manner which deals with the agency problem because of the compositions and consequently to the level of self-government. In addition the scope of reviewing they may decide whether ‘best contracting strategy’ and the probability of dismissal. It is clear from the above mentioned bank, which has been monitored as stricky and costly. In addition, there is also flaw raised against the other two policies, from that may be done that the agency problem may not simply be resolved (Lin, Chen and Long, 2017).
References
Buckalew, C.R., and Carey, H.C. (2015) Page numbers followed by for t refer to figures or tables, respectively. Agency problem, 122–23 American credit markets, 13 American economy: accounting for growth of, 2–3; domestic perspective of, 2. Enterprising America: Businesses, Banks, and Credit Markets in Historical Perspective, 324(5), p. 285.
ElKelish, W.W. (2018) Corporate governance risk and the agency problem. Corporate Governance: The International Journal of Business in Society, 18(2), pp. 254-269.
Galle, B., and Walker, D. I., (2014) Nonprofit executive pay as an agency problem: Evidence from US colleges and universities. BUL Rev., 94(7), p.1881.
Liang, H., and Renneboog, L. (2018) Is corporate social responsibility an agency problem?. Research Handbook of Finance and Sustainability, 54(8), p. 54.
Lin, H.C., Chen, R.R., and Long, M.S. (2017) THE MULTI-PERIOD AGENCY PROBLEM AND RESULTING DISAPPEARANCE OF SINKING FUNDS. Advances in Financial Planning and Forecasting, 34(8), pp. 189-219.
LUO, Q., and WU, Z. (2016) Agency Problem between Controlling and Minority Shareholders and Corporate Cash Dividend. Journal of Management, 3, p. 010.
Neal, D., and Warren, G. (2015) Long-term investing as an agency problem. New York: Rotledge
Ni, J., Chu, L.K., and Li, Q. (2017) Capacity decisions with debt financing: The effects of agency problem. European Journal of Operational Research, 261(3), pp. 1158-1169.
Stepanov, S., and Suvorov, A. (2017) Agency problem and ownership structure: Outside blockholder as a signal. Journal of Economic Behavior & Organization, 133(5), pp. 87-107.
Tyson, S. A. (2018) The Agency Problem Underlying Repression. The Journal of Politics, 80(4), pp. 1297-1310.
Wu, X., Lan, Y., and Liu, H. (2014) Optimal revenue-sharing contract based on forecasting effort for uncertain agency problem. International Journal of Machine Learning and Cybernetics, 5(6), pp. 971-979.
Yang, D.W., and Choi, W.S., (2016) The empirical study on relationship between agency problem and beneficiarys performance. Journal of the Korea Academia-Industrial cooperation Society, 17(4), pp. 615-621.
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