Agency Theory Q1) Define the meaning of Agency Theory?

A theory explaining the relationship between principals, such as a shareholders, and agents, such as a company's executives. In this relationship the principal delegates or hires an agent to perform work. The theory attempts to deal with two specific problems: first, that the goals of the principal and agent are not in conflict (agency problem), and second, that the principal and agent reconcile different tolerances for risk. Q2) Define the meaning of Agency Cost and who will bear the cost? The diverging interests of the various stakeholders (shareholders, managers, and creditors) in a company generate a number of costs called agency costs. These comprise: the cost of monitoring managers' efforts (control procedures, audit systems, performance-based compensation); the costs incurred by the agents to vindicate themselves and reassure the principals that their management is effective, such as the publication of annual reports; residual costs. Whenever managers of an organization pursue their personal objectives at the expense of the organizations shareholders, it creates an agency cost. Examples of agency costs can be simple things like taking advantage of the company through personal use of the telephone, a country club membership, or a corporate jet. They can also be actions performed by managers that may enrich themselves at the ultimate expense of the corporation and its shareholders, such as entering into a value destroying merger in order to expand their own power.

Q3) an organization can face with two agency conflicts mainly conflict between the managers and the shareholders and conflict between debt holders and shareholders. You are required to describe the two agency conflicts and reason why these conflicts arise? Time Horizon Agency conflicts Conflicts of interest may also arise between shareholders and managers with respect to the timing of cash flows. Shareholders will be concerned with all future cash flows of the company into the indefinite future. However, management only be concerned with company cash flows for their term of employment, leading to a bias in favour of short term high accounting returns project at the expense of long term positive NPV projects . Earnings retention conflicts Managers may increase retained earnings in order to finance some project which would not necessarily enhance shareholders wealth. Such grandiose managerial investment policies may not produce results to the shareholders as it may be to management. The resultant growth grants to management a larger power base, job security, greater status and ability to dominate the board and award themselves with higher levels of remuneration. On other hand, shareholders would prefer higher cash distributions, especially where the company has few internal Net Present Value investment opportunities, hence producing a clash of interest between principal and agent.

One particularly important agency issue is the conflict between the interests of shareholders and debt holders. In particular, following a more risky but higher return strategy benefits the shareholders to the detriment of the debt holders.

It can easily be seen why debt holders lose out: a more risky strategy increases the risk of default on debt, but debt holders, being entitled to a fixed return, will not benefit from higher returns. Shareholders will benefit from the higher returns (if they do improve), however if the risk goes bad, shareholders will, thanks to limited liability, share a sufficiently bad loss with debt holders. Q4) Explain in details the mechanisms/ actions that can curb or reduce these two agency conflicts. Give at least three mechanisms that can reduce the conflict between shareholders and managers while only one for the other conflict. Please provide an example in each of your four arguments. Shareholders and managers Corporate governance Corporate governance mechanisms and controls are designed to reduce the inefficiencies that arise from moral hazard and adverse selection. For example, to monitor managers' behaviour, an independent third party (the external auditor) attests the accuracy of information provided by management to investors. An ideal control system should regulate both motivation and ability. Internal corporate governance controls Internal corporate governance controls monitor activities and then take corrective action to accomplish organisational goals. Examples include:

Monitoring by the board of directors: The board of directors, with its legal authority to hire, fire and compensate top management, safeguards invested capital. Regular board meetings allow potential problems to be identified, discussed and avoided. Whilst nonexecutive directors are thought to be more independent, they may not always result in more effective corporate governance and may not increase performance. Different board structures are optimal for different firms. Moreover, the ability of the board to monitor the firm's executives is a function of its access to information. Executive directors possess superior knowledge of the decision-making process and therefore evaluate top management on the basis of the quality of its decisions that lead to financial performance outcomes. It could be argued, therefore, that executive directors look beyond the financial criteria.

Internal control procedures and internal auditors: Internal control procedures are policies implemented by an entity's board of directors, audit committee, management, and other personnel to provide reasonable assurance of the entity achieving its objectives related to reliable financial reporting, operating efficiency, and compliance with laws and regulations. Internal auditors are personnel within an organization who test the design and implementation of the entity's internal

control procedures and the reliability of its financial reporting.

Balance of power: The simplest balance of power is very common; require that the President be a different person from the Treasurer. This application of separation of power is further developed in companies where separate divisions check and balance each other's actions. One group may propose company-wide administrative changes, another group review and can veto the changes, and a third group check that the interests of people (customers, shareholders, employees) outside the three groups are being met.

Remuneration: Performance-based remuneration is designed to relate some proportion of salary to individual performance. It may be in the form of cash or non-cash payments such as shares and share options, superannuation or other benefits. Such incentive schemes, however, are reactive in the sense that they provide no mechanism for preventing mistakes or opportunistic behaviour, and can elicit myopic behaviour.

External corporate governance controls External corporate governance controls encompass the controls external stakeholders exercise over the organisation. Examples include:

competition debt covenants

demand for and assessment of performance information (especially financial statements) government regulations managerial labour market media pressure takeovers

Creditor Monitoring and Disciplining. Creditors have some control rights in companies and hence are also important players in corporate governance. Creditors can influence major decisions of companies and, through a variety of controls, discipline companies that default on debt payments or violate debt covenants. The very fact that creditors provide short term loans and borrowers have to come back to them at regular intervals for more funds also gives creditors significant influences. The effectiveness of creditors influence depends on how well they are protected legally. It also depends on their own corporate governance structures. There are two principal forms of debt: bank debt and market debt (i.e., corporate bonds). Bank debt typically takes the form of a bilateral relationship between a borrower and a lender, although this may be undertaken on a syndicated basis. Corporate bonds are fixed income-lending agreements between an issuing company and dispersed bondholders. Borrowers from banks and issuers of corporate bonds have certain contractual obligations, such as promising to make a pre specified stream

of future payments to lenders. However, creditors can also influence corporate decision-making in solvent states. They can impose sanctions over investment policies of a company, including mergers and acquisitions and spin-offs, and impose restrictions on the overall level of borrowing of the company and, if the company is close to insolvency, on dividend payments and other company decisions that may damage their security. If a borrowing firm violates any covenant and, in particular, defaults on a payment, the lender has certain contingent rights, including repossessing some of the firms assets (collateral). The lender also has the opportunity to put the firm into bankruptcy. This threat may prevent managers from investing in poor projects, or force them to sell assets that are worth more in alternative uses. On the other hand, debt as a disciplining device has its costs. Companies may be prevented from undertaking good projects because debt covenants prevent them from raising additional funds; or they may be forced by creditors to liquidate even when it is not efficient to do so.

The effectiveness of debt as a mechanism of corporate governance depends on the quality of monitoring, on how difficult it is to renegotiate in default states and on the extent to which creditors rights are enforceable in the courts. The creditors own corporate governance structures, including regulations and supervision of lending institutions, determine to a large extent the quality of their monitoring. Bank regulations and supervision involve (i) setting minimum entry requirements to guarantee that only suitable institutions and qualified managers operate in the market, (ii) imposing quantitative restrictions on bank operations to promote sound banking practices, and (iii) inspecting banks loan books. Quantitative restrictions include risk-adjusted capital adequacy ratios, portfolio concentration limits by sector and type of borrowers, limits on lending to insiders and other connected parties, and

limits on exposures to different risks with respect to liquidity, maturity and foreign exchanges. Banks usually have much larger stakes in companies than dispersed individual bondholders and hence have stronger incentives to monitor corporate activities. But bank debts reflect bilateral relationships and, when borrowers default, renegotiations may be relatively easier, especially if banks are at the same time equity-holders of or owned by borrowing companies. On the other hand, renegotiating with dispersed bondholders may be difficult in default states and borrowers might be forced into bankruptcy. It has been suggested that the difficulty of renegotiations, and the power of dispersed creditors, might explain why market debt is an uncommon financing instrument. Market debt is used mostly in developed countries, such as the US, that have a strong investment banking ethos and well developed securities laws, and even there market debt is much less common than bank debt. The quality of creditor monitoring and effectiveness of creditor disciplining also depend on the nature of the relationship between creditors and borrowers. In some countries, creditors, including banks and non-bank financial institutions, and nonfinancial corporations are often interlocked through ownership arrangements. These can take the form of either financial institutions owning non-financial companies, or non-financial companies owning banks and non-bank financial institutions.

An example of the latter occurs when a commercial or merchant bank is an affiliate of a conglomerate or business group. The interlocking ownership relationship between creditors and borrowers could compromise the role of creditors as external agents in monitoring and disciplining borrowers, especially when bank and financial regulations and supervision are weak.