Introduction to the

Agency Theory

Budi PurwantoDepartment of ManagementBogor University of Agriculture

Introduction

Corporations managed through principal-agent relationship

◦Agency problem

◦Agency costs

◦Agency theory

Positive theory of agency◦ Self-interest of

individuals◦ Agency costs should

minimized through Pareto-efficient contract

◦ Empirical approach

Principal-agent literature◦ Self-interest of

individuals◦ Agency costs should

minimized through Pareto-efficient contract

◦ Mathematical approach Game theory

The development of the theory

The basic goal of financial management: to create stock-holder value

Agency relationships:1. Stockholders versus managers2. Stockholders versus creditors

Agency Problems

An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent.

Principal-agent relation

No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. You own 100 percent of the firm.

If you are the only employee, and only your money is invested in the business, would any agency problems exist?

An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them.

If you expanded and hired additional people to help you, might that give rise to agency problems?

Acquiring outside capital could lead to agency problems.

If you needed additional capital to buy computer inventory or to develop software, might that lead to agency problems?

Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors.

Would it matter if the new capital came in the form of an unsecured bank loan, a bank loan secured by your inventory of computers, or from new stockholders?

Conflicts between stockholders and managers.

Conflicts between stockholders and creditors.

There are 2 potential agency conflicts:

Would potential agency problems increase or decrease if you expanded business operations?

Increase. You could not physically be at all locations at the same time. Consequently, you would have to delegate decision-making authority to others.

Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk.

If you were a bank lending officer looking at the situation, what actions might make a loan feasible?

1. Structuring compensation packages to attract and retain able managers whose interests are aligned with yours.

As the founder-owner-president of the company, what actions might mitigate your agency problems if you expanded beyond your home campus?

(More…)

2. Threat of firing.

3. Increase “monitoring” costs by making frequent visits to “off campus” locations.

Would going public in an IPO increase or decrease agency problems?

By going public through an IPO, your firm would bring in new shareholders. This would increase agency problems, especially if you sell most of your stock and buy a yacht. You could minimize potential agency problems by staying on as CEO and running the company.

“Reasonable” annual salary to meet living expenses

Cash (or stock) bonus Options to buy stock or actual shares of

stock to reward long-term performance Tie bonus/options to EVA

What kind of compensation program might you use to minimize agency problems?

Jensen and Meckling (1976) use agency cost to argue that the probably distribution of cash flow provided by the firm is not independent of its ownership structure and that this fact may be used to explain optimal leverage◦ There is an incentive problem associated with issuance

of new debt (agency cost of debt)◦ There are agency costs associated with external equity

The agency cost of external equity may be reduced if the management and shareholder agree to hire independent auditor (Watts and Zimmerman, 1979)

Agency Cost – another equilibrium theory of optimal capital structure

Titman (1984) suggest that agency costs are important for contracts (whether implied or explicit) between the firm and its customers or between the firm and its employees◦ Firm that produce durable goods will have lower

demand for their product if their increase their probability of bankruptcy by carrying more debt

◦ Firms that use a larger percentage of job-specific human capital will also tend to carry less debt, ceteris paribus.

Agency cost not be limited to costs associated with providing debt and equity capital

Jensen, Michael C. and William H. Meckling. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360.

Fama, Eugene F. 1980. Agency Problems and the Theory of the Firm. The Journal of Political Economy, Vol. 88, No. 2. (Apr., 1980), pp. 288-307.

Fama, Eugene F. and Michael C. Jensen. 1983. Agency Problems and Residual Claims. Journal of Law and Economics, Vol. 26, No. 2, Corporations and Private Property: A Conference. Sponsored by the Hoover Institution. (Jun., 1983), pp. 327-349.

Harveya, Campbell R. and Karl V. Linsc, and Andrew H. Roper. The effect of capital structure when expected agency costs are extreme. Journal of Financial Economics 74 (2004) 3–30.

References

Thank you!