The Agency Problem free essay sample

The preliminary and primary goal of a company is to maximize its firm value, in other words, to maximize the shareholders’ wealth. As a good instrument tool of measuring the firm value or the operation condition of a company, the share price indicates the stock market value of the company’s shares. Shareholders always expect to maximize the share price by corporate governance, however, managers in company always link their attitude to the their own interest, and they would not to try their best to achieve shareholder’s goal. Due to different interests in shareholders and managers, the conflicts always exist between them. An agency problem occurs when the interests of stockholders, the board of directors, and/or the management of the company are not perfectly aligned or when these entities conflict. EXPLAINATION Agency problem is typically caused by two reasons which are asymmetric information and hidden action. There is no legitimate theoretical or moral objection to those who assert that the goals of the modern corporation should be to serve the broad interests of all stakeholders rather than to serve the narrow interests of just the shareholders. In a large company, the principle refers to the shareholders of the company and the agent refers to the managers who is the subordinates in the company. Due to the separation of the ownership, managers are always responsible for the more detailed jobs (including job planning, supervising the sales ),the owner of the company do not have to supervise all the business in firm and managers sometimes would maximize their own profit. The behaviour mentioned before is hidden action. Moreover, managers have to run the company on a day-to-day basis, hence they hold more information related to the jobs or tasks. This will lead to different strategies and tactics made by managers, and managers could attach the documents such as financial reports and the accounting data but the shareholders only have the access to the annual reports. Hence there is a problem of hidden information which means managers may keep some information for their secrets instead of reporting to the shareholders. As a result, managers may pay attention to their own interest or profit primarily instead of the firm value then the company have to afford the agency cost. According to the agency problem, some obvious conflicts between owners and managers formed agency cost. For instance, some managers would over-consuming the perks in the company, they may use the company public resources as their own resources. It incurred in cars, office equipments and managers often use the company resource after work, for example, a manager drive the company car to pick up his friends for dinner and if he did this every single day, there will be a certain amount of cost to the company. Another example is that a manager may come up with sub-optimal decision for expansion or larger market volume. It supposed that Nokia is not well-performanced in market and the manager of the Apple company may consider to merge the Nokia company and buy the company in a cheaper price. Hence to do so, it seems that Apple has larger market volume but their performance may not still keep as well as before, in other words, empire building. The Adidas company bought the Reebok company several years ago, but larger market volume do not assist Adidas to compete against Nike, and this is still a kind of agency problem. Consequently, these conflicts and incorrect decision or expansion formed barrier of the profit-maximizing. In addition, managers have to focus on only one project and decide to accept or reject the project by its NPV value. It brings more risk to managers compared to shareholders because the owners or shareholders of the company could have number of choices of investment, in other way to say, shareholders put eggs in different baskets, and it always brings profits for shareholders, however, it’s difficult for managers to take long-term for-profit projects, what managers prefer is the short-run project with low cost. The return for managers is always related to their performance and once they choose the low cost projects, its easier to make a profit for themselves. Mentioned before is still a kind of agency problem. To choose the correct corporate management in a company is necessary to solve the agency problem. Corporate governance describes the various mechanisms and institutions, including law, contract, and norms, by which shareholders and other outside investors attempt to assure themselves that management will be faithful guardians of their investments. Some of the governance may lead to a cost to the company, for instance, the following three items belong to agency cost which are designing the contract, enforcing the contract and the residual loss respectively. According to Journal of Economic Literature (March 2010), one firm has more of the attribute but weaker performance, while the other firm has less of the attribute but better performance (which is indicated as in the diagram), and companies hence have to take correct steps of strategies instead of just putting more governance attribute. To avoid these cost, the company take the potential safeguards as steps. The main parts are organisational structure, external audit, remuneration packages. Organisational structure is to set more positions for managers instead of the owner of the company only. The advantages for this is that more managers in the company such as operating manager and financial manager, they could monitor each other and it saves time for the owner to supervise the two departments. Managers have their competition in company and once one of the managers put more effort on work, the others would put the same effort due to the competition pressure. As a positive circle, all the managers would do contributions to the company instead of considering their own profit before the firm value. Second one is the external audit. The external audit plays important role in checking whether the reports for investors are correct or not. Managers may hide some information about the financial data and the audit could find the incorrect item and the report the error to the shareholders on time so that make sure the reliability of the data and reports. The remuneration package is still an efficient approach to take the company into correct situation. In broad terms, compensation packages for managers and directors include cash, stocks and stock options. Agency theory tells us that the extent of ? nancial leverage in the corporate capital structure (i. e. , the debt-equity mix) has signi? cant managerial incentive effects. In some companies, shareholders show the reference on the stock option. Stock option is a kind of incentive option which allows the managers or directors buy the shares as much lower price as the market price. Managers are willing to do this but once they buy more shares of the company, they would become be part of owners, the potential risk is that if the share price of the company is going down, the managers share price would go down together. CONCLUSION Agency problem seems to form a barrier of the development of the company but shareholders could reduce the agency cost even remove the problem through correct management. If managers have a disutility of e? ort and are paid a wage then they will have an incentive to shirk rather than act in shareholders’ interests. It is therefore important that managers’ incentives are aligned with those of shareholders. Managers would finish their jobs efficiently once they are in profit-maximizing situation. Maybe the situation makes a cost to the company, hence shareholders have to find a balance of this as a result so that the firm value and the managers’ profit are maximising in synchrony.