Agency Problem Essay Example for Free

Agency Problem EssayFinancial Management (Agency problem) Prepargond by Sami Hassan Saeed Singabi August 2008 ingress Economic science teaches us that due to their subjective needs, individuals have subjective preferences, and hence different pertain. Occasionally different subjective interests give rise to conflicts of interest amongst contracting partners. These conflicts of interest may result in turn, in unmatchable or both parties undertaking actions that may be against the interest of the opposite contracting partner.The primary reason for the divergence of objectives between managers and shareholders has been attributed to separation of ownership (shareholders) and control (management) in associations. As a consequence, agency problems or principal-agent conflicts exist in the firm. Agency theory deals with such problem. Agency theory is concerned with how these agency problems chance on the form of the contract and how they can be minimized, in particular, when co ntracting parties are variously informed (or uncertain). Agency problemA problem arising from a conflict of interest between principals such as investors and agents acting for them, such as brokers or managers. Agency problem refers to a conflict of interest arising between creditors, shareholders and management beca utilization of differing goals. It exists due to problems in corporate governance. A typical problem is that of elderly management of a company, who are charged with running the business in the interests of shareholders choose instead to operate to maximize their own interests. A simple instance is the hired anager who fills his pockets at shareholders expenses. For example, an agency problem exists when management and shareholders have conflicting ideas on how the company should be run. Agency problems that arise in a corporation have troubled economists for some time. There are a number of mechanisms that have been used to try and reduce these agency problems. Many of these mechanisms try to get together the managers compensation to the performance of the firm. Typical examples include performance shares, restricted origination grants, and executive stock options.This dissertation is an empirical study of whether the use of executive stock options has in fact reduced the agency problems between managers and stockholders. In this dissertation, two different testing methodologies are used to address the agency problem lessening issue. One methodology looks at some significant event such as a merger or divestiture to see if an executives holding of stock options affect what decisions are made. For example, do larger holdings of stock options motivate managers to take on riskier investments? By increasing the risk of the firm, managers can increase the value of the stock options. other question of interest is whether in taking on risky investments do executives increase the leverage of the firm? By increasing the leverage of the firm, the execu tive efficiency increase the risk of the firm and thus the value of the option holdings. An agency relationship An agency relationship arises whenever one or to a greater extent individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision-making authority to the agents. The primary agency relationships in business are those - (1) betwixt stockholders and managers and 2) Between debt holders and stockholders. These relationships are not necessarily harmonious indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals. These relationships are not necessarily harmonious indeed, agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals. Expansion increase potential agency problems, if you grow to additional locations you could not physically be at all locations at the same time.Consequently, y ou would have to delegate decision-making authority to others. Creditors can protect themselves by (1) Having the give secured. (2) Placing restrictive covenants in debt agreements. (3) They charge a higher than normal interest rate to compensate for risk. Agency address A type of internal cost that arises from, or must be paid to a manger acting on behalf of shareholders. Agency cost arises because of core problems such as conflicts of interest between share holders and management.Shareholders wish for management to run the company in out that increases shareholders value, but management may wish to grow the company in away that maximize their personal power and riches that may not be in the best interest of shareholders. Agency costs are inevitable at bottom an organization whenever shareholders are not completely in charge the cost can usually be best spent on providing proper stuff and nonsense incentives and moral incentives for agents to properly execute their duties, th ereby aligning the interests of shareholders (owners) and agents.The principals (the shareholders) have to find ways of ensuring that their agents (the managers) act in their interests. This means incurring costs, agency costs, to (a) proctor managers behavior, and (b) create incentive schemes and control for managers to pursue shareholders wealth maximization. Various methods have been used to try to align the actions of senior management with the interests of shareholders, that is, to achieve goal congruousness. Linking rewards to shareholder wealth improvements Owners can grant directors and other senior managers share options. These ermit the managers to purchase shares at some date in the future at a price, which is fixed in the present. If the share price rises significantly between the dates when the option was granted and the date when the shares can be bought the manager can make a fortune by buying at the pre-arranged price and then selling in the market place. The manager s under such a scheme have a clear interest in achieving a rise in share price and thus congruence comes about to some extent. An alternative method is to dish out shares to managers if they achieve certain performance targets, for example, growth in earnings per share or return on shares.Sackings The threat of being sacked with the accompanying abjection and financial red may encourage managers not to diverge too far from the shareholders wealth path. However this method is seldom used because it is often rugged to implement due to difficulties of making a coordinated shareholder effort. Selling shares threat and the take- over Most of the large shareholders (especially institutional investors) of quoted companies are not active to put large resources into monitoring and controlling all the firms of which they own a part.Quite often their first response, if they observe that management is not acting in what they call for as their best interest, is to sell the share rather tha n intervene. This will result in a lower share price, making the raising of cash more difficult. If this process continues the firm may become vulnerable to a merger bid by another group of managers, resulting in a loss of top management posts. Fear of being taken over can establish some sort of backstop position to prevent shareholder wealth considerations being totally ignored.Corporate governance regulations There is a considerable range of legislation and other regulatory fight downures (e. g. the Companies Act) designed to encourage directors to act in shareholders interests. Within these regulations for example, the board of directors is not to be dominated by a single individual acting as both the chairman and chief executive. in addition independently minded non-executive directors should have more power to represent shareholder interests in particular, they should predominate in decisions connected with directors remuneration and auditing of firms accounts. data flow The accounting profession, the stock exchange, the regulating agencies and the investing public are continuously conducting a battle to encourage or force firms to release more accurate, timely and detailed information concerning their operations. An improved quality of corporate accounts, annual reports and the availability of other forms of information flowing to investors and analysts such as company briefings and press announcements help to monitor firms, and identify any wealth-destroying actions by wayward managers early. ConclusionDiffuse ownership of publicly held companies reduces the owners ability to monitor managers because they would have to bear the good monitoring costs while gaining only a small marginal benefit. Managers may therefore act to maximize their wealth through personal use of corporate assets, stock manipulation and sub optimal decisions at the owners expense. Thus agency theory practical mechanism is weak, because it is unable to provide practical conclusi ons with regard to agency problems. References 1. Wikipedia, the free encyclopedia. htm 2. www. referenceforbusiness. com 3. Financial-dictionary. The free dictionary. com