What Are Agency Costs? Included Fees and Example

Strategists are concerned not only with agency costs (internal to the firm) but also with the TRANSACTION COSTS of using external markets. Together these can be important considerations in influencing the extent of VERTICAL INTEGRATION/DISINTEGRATION. Whilst in theory the concept was sound, it meant that Enron’s management could now deceive the markets for their own monetary gain, and they did just that.

For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client’s best interest. Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal’s or client’s best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court’s assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

There are a number of regulations and laws that define the relationship between the principal (debtholder) and the agent (management), aimed to minimize the effects of the conflict of interest. Enron, a U.S. energy giant operated for decades trading large and highly demanded commodities. However, 2001 saw the fall of the giant as a result of poor management, and a deeply rooted principal-agent problem. In plumbing, for example, a plumber might make three times the money recommending a service that the agent doesn’t need.

  1. The costs resulting from these conflicts are known as the agency cost of debt.
  2. As a result, many employers are implementing various human resource management strategies to reduce these agency costs.
  3. Though effects of agency cost are present in any agency relationship, the term is most used in business contexts.
  4. Poor financial decisions, in turn, can lead to poor business decisions, which can result in lost revenue and customer trust.

Here’s what you need to know about how agency costs affect corporations and some common examples you may find in the real world. Bondholders typically value a risk-averse strategy since they do not benefit from higher profits. Stockholders on the other hand have an interest in taking on more agency cost definition risk. This is the total compensation you will receive from your employees (and their employers). It consists not only of salary and benefits but also perks, incentives and bonuses. If you don’t manage agency costs, you could end up spending more than you need to on your overhead costs.

Understanding Agency Cost

As such, he brought a successful action in minority oppression in order to force the payment of dividends by the Ford Motor Co. Mr Dodge’s inability to receive a dividend without litigation is another example of agency cost. The article “Large shareholders and corporate control”[26] was published in the Journal of Political Economy in 1985. The paper provides a theoretical framework that illustrates the role of large shareholders in corporate governance and control. For instance, large shareholders can be crucial in solving agency problems between managers and other shareholders. In addition, they can monitor managers and intervene when necessary in order to protect their profits.

These incentives seek a way to optimize the relationship between principals and agents. These are examples of how agency theory is used in corporate governance. In 1995, the paper “The Provision of Incentives to Firms”[31] was published in the Journal of Economic Literature and comprehensively reviewed the literature on providing incentives to firms. The authors pointed out that incentives are crucial for employee motivation and improving firm performance. However, the design of each incentive programme is critical to its success. The authors claim that, by providing for the interests of both employees and managers, HR systems can help reduce labour agency costs.

Agency costs can occur when the interests of the executive management of a corporation conflict with its shareholders. Shareholders may want management to run the company in a certain manner, which increases shareholder value. In the four years leading up to Enron’s bankruptcy filing, shareholders lost an estimated $74 billion in value.

These shareholders can exercise significant control over the company as well as cause conflicts of interest between concentrated and other shareholders. Such decisions may adversely affect the rights of other shareholders or the long-term survival of the company. The agency cost of debt is the increase in the cost of debt or the implementation of debt covenants for fear of agency cost problems. Debt financiers in a company are not in control of their money – company management is.

Understanding Agency Theory

Agency costs are the costs of disagreement between shareholders and business managers. Shareholders and managers often find themselves in disagreement about the best moves a company can make, and this is known as the “agency problem.” Costs stemming from agency problems are agency costs. During a business trip, a company sends three directors to close a deal.

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Agency Costs, Risk Management, and Capital Structure (Digest Summary)

An agent may act in a way that is contrary to the best interests of the principal. The principal-agent problem is as varied as the possible roles of principal and agent. It can occur in any situation in which the ownership of an asset, or a principal, delegates direct control over that asset to another party, or agent. For example, a home buyer may suspect that a realtor is more interested in a commission than in the buyer’s concerns. These practices have led to concerns that management will endanger long-term company growth in order to boost short-term profits and their own pay. This can often be seen in budget planning, where management reduces estimates in annual budgets so that they are guaranteed to meet performance goals.

For example, performance-based compensation, such as profit sharing or stock options, or even a variety of non-monetary incentives, may successfully motivate management to better act in the best interests of principals. Say, for example, shareholders want to undertake a project that will increase the stock value. However, the management team is afraid that things might turn out badly, which might result in the termination of their jobs. If management does not take on this project, shareholders lose a potentially valuable opportunity. This becomes an indirect agency cost because it arises out of the shareholder/management conflict but does not have a directly quantifiable value. In cases where the shareholders become particularly distressed with the actions of a company’s top brass, an attempt to elect different members to the board of directors may occur.

Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners. A principal-agent problem can arise as the interest of the roofer may not be the same as yours. The roofer, knowing that he is paid hourly, may try to take as much time as possible to fix the roof so that he can make more money. You are unable to prevent this, as you know very little about repairing roofs. The agency cost is the extra amount you pay the roofer to get the roof fixed. In Enron’s collapse it also took down its accounting counterpart firm, Arthur Andersen, who were certifying Enron’s books to be clean, when they very obviously weren’t.

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