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Subject 2. Agency Theory

Problems can arise in a business relationship when one person delegates decision making authority to another. Agency theory offers a way to understand why managers do not always act in the best interests of stakeholders.

An agency relationship occurs whenever one person delegates decision-making authority to another. The principal is the person delegating authority, and the agent is the person to whom the authority is delegated.

The agency problem is that principals and agents may have different goals, and therefore, that agents may act in ways that are not in the best interests of their principals.

  • Information asymmetry: Agents almost always have more information. Thus, it is difficult for the principals to measure the agent's performance or to hold them accountable for their performance.

  • On-the-job consumption: Managers can use their decision-making authority and control over corporate funds to satisfy those desires at the expense of stockholders.

    Boards of directors typically make executive pay decisions, in order to control expenses. However, CEOs can use their influence with the board to get pay increases. The historically high level of CEO pay in the U.S. can be attributed to this cause.

  • Empire building: To increase power, status, and income, a CEO might engage in buying many new businesses to increase the size of the firm through diversification. Empire building, which is diversifying without an appropriate reason for doing so, reduces profitability, because funds are now used to pay the debt incurred to finance growth.

The Challenge for Principals

  • Shape the behavior of agents so that they act in accordance with goals set by principals.
  • Reduce information asymmetry.
  • Develop mechanisms for removing agents who do not act in accordance with goals of principals.

The agency problem also exists in the relationship between higher-level managers and their lower-level subordinates. For example, a subordinate may withhold information to increase his pay or job security or get more than his unit's fair share of organizational resources.

Governance mechanisms are put in place by principals to align agents' incentives with their own, and to monitor and control agents.

  • U.S. and U.K. firms tend to rely heavily upon corporate boards of directors, elected by stockholders, to represent the interests of the stockholders.
  • Stock-based compensation for agents: If agents are working under a pay-for-performance system, then it will be in their best interests to increase profitability.
  • The use of independently audited financial statements.
  • The threat of a hostile takeover.
  • When agency relationships exist within a company, such as between supervisor and subordinate, strategic control mechanisms better align the interests of top managers and employees.

Practice Question 1

In the principal-agent framework, the ultimate principals are:

A. managers
B. board of directors
C. shareholders

Correct Answer: C

Practice Question 2

The agency theory can be applied in the relationships between:

I. Stockholders and senior management.
II. Top management and lower levels of management.
III. Stockholders and debtholders.

Correct Answer: I and II

II: An agency relation is established whenever top management delegates authority to lower levels of management.

Practice Question 3

In agency theory, when a corporation hires an auditor, the auditor is a(n) ______.

A. agent
B. principal
C. loser

Correct Answer: A

Practice Question 4

Aligning the preferences of principals and agents can be used to reduce agency costs. An example is ______.

A. lobbying/political costs
B. financial audits and financial reporting
C. issuing stock options to managers and employees

Correct Answer: C

Practice Question 5

Which one of the following actions would likely reduce conflicts of interest between shareholders and managers?

A. A manager accepts a project with a negative net present value.
B. A manager's compensation is linked to the company's stock performance.
C. A manager who is near retirement focuses on short run performance and customer satisfaction.

Correct Answer: B

Linking the manager's compensation to stock performance aligns the manager's interest with that of shareholders, and reduces conflict.

Practice Question 6

Which of the following statements is not true?

A. Agency costs include managerial perquisite consumption.
B. Agency costs include the monitoring costs of shareholders.
C. The basic financial objective of managers is the maximization of shareholder's wealth.

Correct Answer: C

Study notes from a previous year's CFA exam:

b. discuss problems that can arise in principal-agent relationships and mechanisms that may mitigate such problems;