Agency Costs and Financial Decision-Making

Agency Costs and monetary Decision-Making The Concept An fashion relationship is a contract down the stairs which one or more persons (the principal(s)) engage a nonher(prenominal) person (the gene) to per bod near service on their behalf which involves delegating some decision making authority to the agent. If both parties to the relationship atomic number 18 utility(prenominal) maximizers and they whitethorn experience divergent goals and objectives, and there is good reason to moot that the agent volition not always act in the outdo interests of the principal (Jensen, Michael C. , and William H.Meckling. Theory of the Firm, Managerial Behavior, Agency Costs, and Ownership Structure. Journal of Financial Economics 3 (October 1976), 305-360) The archetype of execution cost recognizes there are fundamental differences in how stockholders, managers, and even bondholders interpret their respective relationships to an organization. While they may share some common goals an d objectives, there is the potential for at to the lowest degree some objectives to emerge that are focused more on person enrichment than on the well-being of the whole.For example, managers may be more focused on building a reputation for themselves, possibly creating their induce power bases inside the anatomical structure of the larger organizations. Shareholders may become more focused on earning dividends now and slight on the future of the railway line. Bondholders may be touch further with the project associated with the bond issue, and lose sight of how the overall stability of the company can have a negative impact on the amends earned from that bond. ( http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. tmlixzz14WVaUW4g) Agency Costs is an economic concept which is defined as the cost get holdred by an entity in relation to issues uniform varied goals and objectives of the perplexity and shareholders and nurture asymmetry. Self-Interested B ehavior Agency theory suggests that, in imperfect labor and capital markets, managers go forth seek to maximize their give utility at the expenditure of corporate shareholders. Agents have the ability to lease in their consume self-interest rather than in the crush interests of the loaded because of asymmetric information (e. g. , managers know mend than shareholders whether they are apable of meeting the shareholders objectives) and suspense (e. g. , myriad factors contri thate to final outcomes, and it may not be plain whether the agent directly caused a given outcome, positive or negative). usher of self-interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal put on the line positions, whereby risk-averse managers bypass profitable opportunities in which the firms shareholders would cull they invest. Outside investors recognize that the firm will make decisions contrary to their best interests.Accordingly, investors will discount the prices they are willing to pay for the firms securities. (Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and Incentives. Berlin Springer-Verlag, 1987). A potential agency conflict arises whenever the manager of a firm owns less than 100 percent of the firms common stock. If a firm is a fix proprietorship managed by the owner, the owner-manager will undertake actions to maximize his or her own welfare. The owner-manager will probably measure utility by ad hominem wealthinessiness, but may trade off other considerations, such as empty and perquisites, against personal wealth.If the owner-manager forgoes a portion of his or her ownership by marketing some of the firms stock to outside investors, a potential conflict of interest, called an agency conflict, arises. For example, the owner-manager may prefer a more leisurely lifestyle and not work as vigorously to maximize shareholder wealth, because less of t he wealth will now accrue to the owner-manager. In appendage, the owner-manager may decide to pop more perquisites, because some of the cost of the consumption of benefits will now be borne by the outside shareholders. Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and Incentives. Berlin Springer-Verlag, 1987. ) In the majority of large publicly traded corporations, agency conflicts are potentially quite significant because the firms managers generally own only a small percentage of the common stock. Therefore, shareholder wealth maximization could be subordinated to an assortment of other managerial goals. For instance, managers may have a fundamental objective of maximizing the size of the firm.By creating a large, promptly growing firm, executives increase their own status, create more opportunities for lower- and middle-level managers and salaries, and arouse their job security because an unfriendly takeover is less likely. As a result, incumbent mana gement may pursue diversification at the write down of the shareholders who can easily diversify their individual portfolios simply by purchase shares in other companies. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) Managers can be support to act in the stockholders best interests through incentives, constraints, and punishments.These methods, however, are effective only if shareholders can observe all of the actions taken by managers. A moralistic hazard problem, whereby agents take unobserved actions in their own self-interests, originates because it is infeasible for shareholders to oversee all managerial actions. To reduce the moral hazard problem, stockholders must incur agency be. Measuring Agency Costs The idea behind assessing agency cost is to attempt to identify what impact these differences in objectives and the flow of information between the agent or manager and the shareholders is having on the overall positiveness of the organization.By correctly identifying and addressing issues of agency cost, it is possible to minimize the stoop of those factors, at to the lowest degree enough to allow the organization to continue moving forward, rather than rails the risk of failure. Determining the agency cost normally begins with looking about at the potential costs or risks associated with including some type of agent or manager in the organizational structure. For example, one potential risk would be the possibility that the individual who is appointed as an officer in the company could seek to use company assets for his or her own personal gain, to the detriment of the company.At the same time, agency cost also looks at the expense involved in anticipating potential ill-treats of power and resources, and structuring the organization so that abuse is less likely to occur. This may include offering incentives to key implementees that hike loyalty and lessen the chance of misappropriation of resour ces, or structuring the accounting bear on so that a series of checks and balances create a separation of control, efficaciously preventing any one individual from having too much power deep down the organization. http//www. wisegeek. com/what-is-an-agency-cost. htm) Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. The notion of agency costs is perhaps most associated with a seminal 1976 Journal of Finance paper by Michael Jensen and William Meckling, who suggested that corporate debt levels and management equity levels are both influenced by a wish to brook agency costs. There are three major types of agency costs 1) Expenditures to monitor managerial activities, such as audit costs (2) Expenditures to structure the organization in a way that will limit unsuitable managerial behavior, such as appointing outside members to the board of directors or restructuring the companys business units and management hierarchy (3) Opportunity costs which are incurred when shareholder-impresent restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that distribute shareholder wealth.In the absence of efforts by shareholders to alter managerial behavior, there will typically be some loss of shareholder wealth repayable to inappropriate managerial actions. On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed with shareholder interests. Therefore, the optimal amount of agency costs to be borne by shareholders is unflinching in a cost-benefit contextagency costs should be increase as long as each incremental dollar worn out(p) results in at least a dollar increase in shareholder wealth. (http//www. referenceforbusiness. om/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) Financial decision making for relationss wi th agency costs There are two polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firms managers are compensated entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firms gain would be affected by economic events that are not under managerial control.At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive requital is tied to instruction execution, but some monitoring is also undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders interests (1) consummation-based incentive plans (2) direct interjection by shareholders (3) the threat of firing (4) the threat of takeoverMost publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firms managers earn more shares. If performance is below the target, however, they ascertain less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives.First, they offer executives incentives to take actions that will enhance shareholder wealth. Second, these plans help companies attract and retain managers who have the cartel to risk their financial future on their own abilitieswhich should lead to better performance. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) An increasing percentage of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds.The institutional money managers have the clout, if they choose, to maintain considerable influence over a firms operations. Institutional investors can influence a firms managers in two primary ways. First, they can meet with a firms management and offer suggestions regarding the firms operations. Second, institutional shareholders can sponsor a aim to be voted on at the annual stockholders meeting, even if the proposal is argue by management.Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clear influence management opinion. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) In the past, the likelihood of a large companys management being ousted by its stockholders was so remote that it posed little threat. This was true because the ownership of most firms w as so widely distributed, and