Lecture 5 - Agency Theory PDF

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Lecture Notes on Agency Theory...

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Lecture Five - Agency Theory Agency Theory - teaches that self interest leads to a conflict between ‘principals’ (shareholders) & ‘agents’ (managers). Managers, being opportunity cannot be trusted to maximise shareholder interest rather than their own. The study of incentives to motivate - examines the relationships between an agent and a principal. Principal is a person/entity that delegates responsibility to another, known as the agent Agent acts on behalf of the principal Agency theory explains how best to organise relationships in which one party (principal) determines the work, which another party (agent) performs Agency problems are created when the shareholders (principals) hire managers (agents) to make decisions that are in the best interests of the shareholders. People are self interest and will therefore have conflicts on interest in any cooperative endeavours - (Jensen, 1994) Naturally follows that some decisions of managers are motivated by self-interest According to agency theory, information asymmetry occurs where management (Agents) have the advantage of access to information within the company that the owners (principals) don't have. This results in the principal’s inability to control the desired action of the agent. Information assymetry - when one group of participants has better or more timely information than other groups. Agency costs - the costs resulting from managers misusing their position, as well as the costs of monitoring & disciplining them to prevent abuse. Jensen & Meckling - An agency relationship is in the form of a contract which on or more persons (the principal) engage another person (the agent) to perform some service on their behalf, which involves delegating some decision making authority to the agent. An agent responds to incentives & will not always act in the best interest of the principal The agency contract spells out the terms of the agency relationship. The contract outlines the compensation to me made by the principal to the agent, given that a set of conditions are met The principal & the agent tend to have different objectives. The principles objective is to maximise the value of the agents’ productivity minus the cost he must pay the agent. The agent maximises their own utility. Contract can provide incentives & align interest. The differing objectives of the principal and the agent implies there is a need for an alignment of their objectives. The mechanism for achieving this alignment can occur through some form of contracting. Contracting is made difficult due to hidden actions & hidden information. Contracting should focus on performance measures which are visible. Jensen & Meckling (1976) ”Theory of the Firm:Managerial Behaviour, Agency Costs & Capital Structure” - argue agency costs (i.e. monitoring costs, economic bonding costs & residual loss) are an unavoidable result of the agency relationships. They concluded that on the level of agency cost depends, among other things, on statutory & common law & human creativity in devising better contracts. Monitoring Costs Incurred when the principals attempt to monitor or rustic the actions of agents e.g the board of directors at a company acts on behalf of shareholders to monitor & restrict the activities of management to ensure behaviour that maximises shareholder value. Costs associated with issuing financial statements are also monitoring costs. Bonding Costs Incurred by agents when they establish mechanism to signal to principals that they will behave in the interests of the principal or will compensate the principal if they fail to do so e.g an agent may commit to contractual obligations that

limit or restrict the agent’s activity e.g a manager may agree to stay with a company even if the company is acquired. The manager must forego other potential employment opportunities. That implicit cost would be considered an agency bonding cost. Costs of Monitoring Alternatives to monitoring include: Constraints on agent’s behaviour, Incentives to align agent’s interests with the principal’s interest, Punishment for agent misbehaviour, Principle-agent contracts that eliminate all agency problems cannot be designed. A residual agency problems remains Agency Costs Costs incurred in an attempt to push agents to act in the principal’s best interest. Incremental costs of working through others. Consists of three types: Direct contracting costs, monitoring costs, loss of principal’s wealth due to residual unresolved agency problems. Residual Loss Loss incurred ‘by the principal’ because the agent’s decisions do not serve its interests. The costs incurred from divergent principal & agent interests despite the use of monitoring & bonding. Agency loss is more severe when the economic interest or economic values of the principal and agent diverge substantially & informations monitoring is costly. The Agency Problem Agency theory makes two assumptions - a ‘principal’ has different objectives/goals than the ‘agent, there is asymmetric information between the ‘principal’ and the agent’ - either the principal doesn't know the objectives of the agent or the principal does not observe how the agent behaves. In corporate finance, the agency problem usually refers to a conflict of interest between a company’s management and the company’s stockholders. The manager, acting as the agent fo the shareholders, or principals, is supposed to make decisions that will maximise shareholder wealth. However, it is in the managers’ own best interest to maximise his own wealth Not possible to eliminate the agency problem completely, the manager can be motivated to act in the shareholders’ best interests through incentives, such as performance-based compensation, direct influence by shareholders, the threat of firing & the threat of company takeovers by other companies - free market for corporate control. Tesco - overstating profits - some managers bonuses dependent on profits - fraud investigation. Monitoring Agents The principal can monitor the agent’s actions, but not perfectly. Costs are incurred in monitoring the agent’s behaviour. Perfect monitoring of all actions of the agent can eliminate the agency problem. This can be prohibitively costly & can never be perfect Roman Abrahamovic hiring a footballing expert to check whether the manager is doing their job, causes possible conflict & expensive. Causes of information asymmetry: Remoteness of principal to the information (e.g shareholder is not involved in dayto-day business of the company), agent is likely to supply biased information to the principal e.g manager may overstate profitability, information is complex, high volume of information. 2008 - Banking crisis - rating agencies & financial journalists - Robert Peston one journalist who was doing their job properly blamed by the banks for causing the crisis by telling people about the problems they had made. Interest Divergence If the utility functions of agents & principals coincide, there is no agency problem; both agents & principals enjoy increases in their individual utility. Agency costs are incurred by the principals when the interests of principals & agents diverge, because given the opportunity, agents will rationally maximise their own utility at the expense of they principals Types of Agency Problems - Moral hazard, Imperfect observability (Holmstrom, 1979) and shirking, - cannot control people all the time as they do not work e.g surfing the web, managers at golf courses, hidden or information asymmetry/hidden action - cannot see whats happening all the time Major issues at the heart of problems in agency relationships: Moral hazard - occurs when there are opportunities to shirk because of incomplete contracting. Imperfect Observability - Occurs when the principal cannot observe the agents actions perfectly. Moral Hazard The agent usually has more information about his or her actions or intentions than the principal does. Principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the view of the principal) if the interests of the agent & the principal are not aligned.

Manager may be lazy or apathetic especially if manager is close to retirement or if manager has little threat of being fired. Managers may spend company’s money on activities that reduce profitability - e.g nice buildings/offices, first class travel. Conrad Black - used The Telegraph’s money to pay for billionaire lifestyle when a millionaire, wife’s birthday party Manager may pay himself too much - problem exists mainly for senior not junior management. Moral hazard can occur when upper management is shielded from the consequences of poor decision making. Situation can occur in a variety of situations - when a manager has a secure position & cannot be readily removed. When a manager is protected by someone higher in the corporate structure, such as in cases of nepotism or pet projects. When a manager may readily lay blame on an innocent subordinated. When there is no clear means of determining who is accountable - bad mortgages. When senior management has its own remunerations as its primary motivation for decision making (hitting short-term quarterly earnings targets or creating high medium term earnings, without due regard for the medium to long term effects on, or risks for the business so that large business can be justified in the current periods). Imperfect Observability & Shirking In some situations observability is easy to achieve, especially when there are outward signs of behaviour that can be measured. In other cases, observability may be difficult to directly achieve - surfing the internet possibly for work or something else. Hidden Information Hidden Action The agent has hidden information or hidden action because it is hard or expensive for the principal to monitor the agent. Leads to information asymmetry. Solutions to the Agency Problem Difficult for principals to know which agents will act in their own self interest, it is prudent for the principals to limit potential losses to their utility. Losses to the principal resulting from interest divergence may be curbed by imposing control structure upon the agent. Objective is to reduce the agency costs incurred by principals by imposing internal controls to keep the agent’s self-serving behaviour in check. Principals may also invest in writing better contracts. To protect shareholder interest, minimise agency costs & agent-principal interest alignment, agency theorists prescribe various governance mechanism: executive compensation schemes & governance structures. Model of the agent remains as inherently opportunistic, in that there is an ever present possibility of opportunism as controls are imperfect. Agency theorists specify an intermediate condition of control, first delegate the responsibility & then controls to minimise the potential abuse of the delegation Executive Compensation Schemes - Financial incentive schemes provide rewards & punishments that are aimed at aligning principal agent interests. Such incentive schemes are particularly desirable when the agent has a significant information advantage & monitoring is problematic. Theoretical Limitations Assumptions made about individualistic utility motivations resulting in principal-agent interest divergence may not hold for all managers. Agency theory provides a useful way of explaining relationships where the parties’ interests are at odds & can be brought into alignment through proper monitoring & a well-planned compensation system. Additional theory is needed to explain other types of human behaviour & this is found in literature beyond the agency perspective. Homo economicus - individualistic, opportunistic, self serving model of man. Rational actor who seeks to maximise individual utility. Both parties are utility maximisers As an agent of the principals, an executive is morally responsible to maximise shareholder utility, however executives accept agent status because they perceive the opportunity to maximise their own utility Corporate Governance - Foundation for topic is Agency Theory, Makes simplifying assumptions about human behaviour, the social responsibility of organisations is to increase their profits - Milton Friedman 1970....