Agency cost
Agency costs refer to the expenses incurred when agents, such as managers, operate on behalf of principals, like shareholders, within a firm. These costs arise from potential conflicts of interest between the two parties, particularly when managers prioritize personal gains over shareholder value. The agency relationship can lead to issues such as asymmetric information, where managers possess more information than shareholders, and adverse selection, where shareholders cannot adequately assess the suitability of management decisions.
Agency costs can be categorized into monitoring costs, which are the expenses shareholders incur to supervise management, and bonding costs, which are commitments made by managers to align their interests with those of shareholders. Despite these measures, residual losses may still occur when managers fail to act in the best interests of the firm, leading to inefficiencies and diminished company value.
To mitigate agency costs, firms often implement strategies like incentive compensation, which ties managers' benefits to the firm's performance, fostering a shared interest in maximizing shareholder value. By understanding and addressing agency costs, shareholders aim to promote effective management practices and ensure that firm resources are utilized for long-term growth and profitability.
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Agency cost
In business and finance, agency costs are the costs incurred when agents manage business activities on behalf of principals within a firm. The costs stem from disagreements between the principals, the owners and shareholders of a firm, and the agents, who are the managers. Disagreements may arise from conflicts of interest, asymmetric information, and adverse selection.
Shareholders want managers to make strategic and organizational decisions for the firm that will maximize its market value. However, managers may act to increase their own wealth, putting their self-interests ahead of shareholder interests.
The divergence of shareholder and manager interests creates agency costs. There are three types of agency costs: monitoring costs, bonding costs, and residual loss. Principals seek to minimize agency costs by aligning shareholder and manager interests. Solutions to agency costs include monitoring, bonding, and compensation incentives.
Background
Agency costs are a part of agency theory, which examines the principal-agent relationship and the problems that result.
Under agency theory, a firm is a collection of contracts. The principal-agent relationship is a contract in which principals enlist agents to perform a service on their behalf. In a firm, the principals are outside investors, and the agents are the managers. The investors delegate control of the company operations to the managers, whose decisions affect the welfare of the firm.
Shareholders and managers may experience conflicts of interest. The shareholders' primary goal is to increase share price and dividends, a portion of the profits that a firm pays to those who own stock in the company. However, managers may make decisions that facilitate the company's growth for the long term while lowering the stock price in the short term. This action contradicts shareholders' interests. Managers may also make organizational decisions that personally benefit themselves as opposed to the company, such as giving themselves a better office, luxury travel arrangements, and bonuses. These actions can cut into profits.
The principal-agent relationship is further complicated by asymmetric information. This occurs when managers have more information than shareholders. Managers may withhold organizational and financial data from shareholders, who are unable to fully monitor the managers. Another obstacle is adverse selection, when managers have information that shareholders cannot readily access. Because of adverse selection, shareholders are unable to gauge whether management decisions are in accordance with their goals.
Conflicts of interest, asymmetric information, and adverse selection make up the agency problem: the potential of managers to act in their own best interests instead of the firm's best interests, also known as opportunistic behavior.
When management makes decisions that deviate from stockholders' preferences, it is called a moral hazard. The divergence from the principals' wishes may affect the price shareholders are willing to pay for their stock. If shareholders disagree with management decisions, they may sell their shares, decreasing the firm's stock price.
Firms encounter agency costs in trying to protect the interests of shareholders. Principals seek to promote efficient business strategies that prioritize the company's welfare over opportunistic behavior. Through agency costs, companies attempt to keep managers in line with shareholder goals and reduce the possibility of opportunistic behavior.
Overview
Agency costs are an inevitable consequence of the principal-agent relationship. Principals bear monitoring costs, while agents bear bonding costs. Both monitoring costs and bonding costs can be justified to reduce the extent of residual loss.
Monitoring costs are the expenses that outside investors incur to supervise management's performance. These include audits, reports, and internal information that are shared among shareholders. Monitoring costs also include practices that control managers' behavior, such as policies and incentive compensation. Another aspect of monitoring costs is maintaining a board of directors. The costs account for holding board meetings, recruiting directors, and paying them, usually through retainers and stock options.
Bonding costs tie managers to shareholder interests through contractual obligations. Managers incur bonding costs to guarantee shareholders they will not partake in opportunistic behavior. Bonding costs may substitute or complement monitoring costs. For instance, managers may agree to report regularly and have their performance audited. They may be bound by their contract to forgo luxury travel options for economic measures. They may also agree to avoid wrongdoing or misconduct.
If shareholder and manager interests continue to diverge despite monitoring costs and bonding costs, the remaining losses are called residual losses. Monitoring and bonding are expensive and can be cost-prohibitive. They may not be enough to control managers' opportunistic tendencies. Residual losses include those that result when managers do not complete their duties, indulge in excessive company benefits, and misuse company funds. By adhering to accounting principles and reporting guidelines, these types of agency costs can be identified relatively quickly and addressed.
Principals can temper agency costs through monitoring and bonding. When shareholders are unable to control manager behavior, it may decrease the firm's value and stock price. Boards of directors play an important role in promoting efficient practices and minimizing residual loss. They can determine budget restrictions that govern manager behavior and enforce operating policies. Boards have the authority to select, remove, and replace a firm's top management.
Shareholders can also address agency costs through incentive compensation. Managers' interests are more likely to align with shareholders if they hold an ownership stake in the company themselves. Through shares and stock options, managers bear the effects of their strategic decisions on their own stock portfolio. Performance-based compensation can also help minimize agency costs, as managers receive raises and bonuses for their performance.
In the principal-agent relationship, managers are prone to act in their own self-interests over the interests of shareholders, resulting in agency costs. Outside investors prioritize increasing market value and dividends, but managers may act in an opportunistic manner that goes against the company's best interests. Shareholders can minimize agency costs by aligning the interests of managers with their own goals through monitoring, bonding, and compensation incentives.
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