Definition of the Agency Problem
- Within corporate finance, the agency problem is considered as the conflict of interest between the company’s managers and its stockholders.
- This conflict occurs when personal interests are given a priority over the professional duties each party needs to fulfill.
- The core of the conflict is that managers want higher compensation, and shareholders want higher profits.
- A secondary conflict is that managers want to re-invest profits in the business, while shareholders may prefer more dividends paid out.
What Impacts the Agency Problem?
- Shareholders, or principals, invest their capital in a business, expecting high returns on their investments.
- Directors act as form a board of directors, which represents the interests of the shareholders.
- The directors hire and fire the managers of the business and work with them to help the managers balance competing forces of profits and growth.
- Managers act as agents for shareholders to ensure that the shareholder’s value is maximized.
- Shareholder value is created from the manager’s ability to generate a growing stream of profit, which can be accumulated in the business or paid out to shareholders as dividends.
- Managers may prioritize maintaining significant retained earnings to invest for future growth, while shareholders may prefer payment of dividends.
- Maintaining a healthy relationship between shareholders and managers causes direct and indirect agency costs.
- Direct agency costs include providing incentives like recognition and compensation to managers or structuring regulations to maintain the relationship.
- Indirect agency costs are opportunity costs for shareholders who may want to invest in other projects outside of this business to generate more value for themselves.
Why is the Agency Problem Important?
- The agency problem is often used as a basis of judgment regarding the working relationship between individuals who play an essential role in a company’s operations.
- It is considered highly unethical by many as it involves exploiting the interests of others for personal benefits.
- For example, if a bank fails to pay interests, which is their obligation, to those who have deposited money in their savings accounts, these individuals might as well keep the money at their homes.
The Agency Problem in Practice
- For example, you may hire a financial advisor to invest your money for the best results. The advisor might invest it in an annuity, to also earn a higher commission.
- Understanding what the advisor’s needs are can be useful in mitigating this conflict of interest. On your end, you could offer a higher compensation right away, based on your relationship with the advisor.
- Let’s take a closer look at how this occurs in corporate finance.
- As a company officer or representative, you may be tempted to increase your share prices to raise the company value. It is unethical, but many companies do it through miscalculations in reports.
- Your shareholders invest more capital into the company, expecting a greater return to make more money.
- This conflict of interest takes away the transparency that is required in maintaining the principal-agent relationship.