Agency Theory in Financial Management
An agency relationship arises when the principal hires an agent to perform some services or the decision-making authority is delegated to the agent. Note Types of Agency Relationships in Finance There are various types of Agency from (b) Creditors as principal and shareholders as agents. (ii) Managers can take non-optimal decisions in investment, financing or labor recruitment. Matthias Kiefer, (Department of Accountancy, Economics and Finance, An analysis of the relationship between managers and shareholders from the work in a hierarchy in which principals attempt to control the actions of agents to achieve.
Agency relationships occur when one party, the principalemploys another party, called the agentto perform a task on their behalf.
Agency theory is helpful in explaining the actions of the various interest groups in the corporate governance debate.
Agency Relationships in Financial Management - My Investment
For example, managers can be seen as the agents of shareholders, employees as the agents of managers, managers and shareholders as the agents of long and short-term creditors, etc. In most of these principal-agent relationships conflicts of interest is seen to exist.
It has been widely observed that the conflicts between shareholders and managers and in a similar way the objectives of employees and managers may be in conflict. Although the actions of all the parties are united by one mutual objective of wishing the firm to survive, the various principals involved might make various arrangements to ensure their agents work closer to their own interests.
For example, shareholders might insist that part of management remuneration is in the form of a profit related bonus. The agency relationship arising from the separation of ownership from management is sometimes characterized as the agency problem.The Principal Agent Problem
For example, if managers hold none or very little of the equity shares of the company they work for, what is to stop them from: Not bothering to look for profitable new investment opportunities? Giving themselves high salaries and perks? Agency theory suggests that, in imperfect labor and capital markets, managers will seek to maximize their own utility at the expense of corporate shareholders.
The Agency Theory in Financial Management | teenbooks.info
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. Shareholders can nominate and elect the board of directors, who oversees the company. Through the board of directors, shareholders can oust management with poor performance. The threat of takeovers: If a firm's stock is undervalued due to poor management, a competitor may acquire the firm even at the opposition of its management.
The acquirer can replace management with their. Shareholders Through Managers vs. Creditors Managers are the agent of both shareholders and creditors. Shareholders empower managers to manage the firm. Creditors empower managers to use the loan.
Taking riskier projects than those agreed to at the outset: Creditors lend money to a firm based on its perceived business and financial risk. If shareholders take riskier investments, the shareholders receive the full benefit of success, but the creditors may share the losses in case of failure.
Borrowing more debt to significantly increase dividends or repurchase outstanding stock: The firm becomes riskier because of increased leverage.
Creditors are hurt because more debt ;will claim against the firm's cash flows and assets.
The Agency Theory in Financial Management
To protect themselves against shareholders, creditors often include restrictive covenants in debt agreements. In the long-run, a firm that deals unfairly with creditors may impair the shareholders' interest because the firm may: Lose access to the debt markets; or Be saddled with high interest rates and restrictive covenants.
Thus, as agents of both shareholders and creditors, managers must treat the two classes of security holders fairly.