LESSON TWO: AGENCY THEORY

Application of Agency Theory in Financial Management

1.1 Introduction
One of the distinctions between accounting and finance is that accounting is historical but
finance is futuristic. Since the future is uncertain, in finance the element of risk is introduced.
For investors to have returns, there needs to be a balance between risk and return and it’s the
work of finance manager to help the business owner is ensuring their returns are assured by
differentiating between returns available and estimated risk in the investment into the venture.
Since the business is growing, the firm will employ staff to manage the business of behalf of
owners of capital, hence the concept and application of agency theory is discussed in details.

The lesson covers:

• Lesson Objectives
• Risk-return Trade off
• Agency theory
• Financial systems
• Major players in Financial Markets
• Types of Financial market structure
• Learning Activities
• Summary
• Further reading.

1.2 Lesson Objectives

By the end of this lesson, you should be able to:

1. Define the two key concepts in finance.

2. Discuss the relationship between risk and return.

3.Discuss the agency theory and its application to business management.

1.3 The Risk-Return Trade-Off

Most financial decisions involve alternative courses of action. The alternatives have different
returns and risk. For example, should we buy a replacement machine now or should we wait
until next year, should we set the debt-to-assets ratio at 20%, 40% or any other ratio?

The higher the risk on any decision, the higher the required return to compensate for this risk.
The relationship between Return and Risk can be expressed as follows:

Required Rate of Return = Risk-free rate + Risk premium.

Risk free rate is compensation for time and risk premium is compensation for risk of financial
actions. It can be seen that the relationship is direct.

The finance manager should avoid decisions with unnecessary risk. In making financing
decisions for example, the finance manager must decide whether to finance with equity alone or
to use debt as well. The expected return when debt is used is high since the cost of debt is low.
However, since payment of interest on debt is compulsory, the risk involved is high.

On the other hand, the cost of equity is high and therefore the return is low. The risk is also low
since payment of ordinary dividend is not compulsory. The firm’s liquidity decisions will also
affect the risk and the return of the firm.

1.4 Agency Theory/ Problem

In a limited company there is separation between ownership and management. The company is
owned by shareholders and managed by the board of directors. An agency relationship arises
whenever one party known as the principal hires another party known as the agent and
delegates decision making authority to that agent to perform duties on his or her behalf. Agency
problem arises whenever the agent performs actions of his own interest instead of pursuing the
interest of the principal
An agency relationship arises where one or more parties called the principal contracts/hires
another called an agent to perform on his behalf some services and then delegates decision
making authority to that hired party (Agent) In the field of finance shareholders are the owners
of the firm. However, they cannot manage the firm because:

• They may be too many to run a single firm.

• They may not have technical skills and expertise to run the firm
 • They are geographically dispersed and may not have time.

Shareholders therefore employ managers who will act on their behalf. The managers are
therefore agents while shareholders are principal. Shareholders contribute capital which is given
to the directors which they utilize and at the end of each accounting year render an explanation
at the annual general meeting of how the financial resources were utilized. This is called
stewardship accounting.

• In the light of the above shareholders are the principal while the management are the agents.
• Agency problem arises due to the divergence or divorce of interest between the principal and
the agent. The conflict of interest between management and shareholders is called agency
problem in finance.
• There are various types of agency relationship in finance exemplified as follows:
1. Shareholders and Management
2. Shareholders and Creditors
3. Shareholders and the Government
4. Shareholders and Auditors
5. Headquarter office and the Branch/subsidiary.

Shareholders and Management

In this relationship shareholders are the principals and managers are the agents. Agency
problem arises whenever management takes some actions that are inconsistent with
shareholders wealth maximization goal. The following are the major causes of conflict between
shareholders and management.
a) Incentive problem- managers may not work hard to maximize shareholders wealth if
they perceive that they will not share in the benefits of their labor hence maximize
leisure at the expense of working hard
b) Huge salaries and benefits- managers may award themselves huge salaries and other
benefits more than what shareholders would consider reasonable.
c) Projects with different risks- managers may undertake projects with different risks
more than what shareholders would consider reasonable.
d) Profitability at risk- managers may undertake projects that improve their image at the
expense of profitability.
 e) Management Buy Out- Management may attempt to acquire the business of their
shareholders through forming a nominee company which would buy the shares of the
company they are managing hence taking control of the company

Solutions to the Conflict

i. Threat of Firing- If managers are not delivering the shareholders may threaten to fir
them during the annual general meeting
ii. Threat of Hostile Take Over-If the shares of the firm are undervalued due to poor
performance and mismanagement. Shareholders can threaten to sell their shares to
competitors. In this case the management will lose their jobs
iii. Offering Performance based Compensation- Management will be compensated based
on their performance through paying bonus and giving managers a stock option.
iv. Incur Agency Cost- These are costs incurred by the firm as a result of agency
relationship so as to minimize adverse effect of agency conflict. These costs include
monitoring costs, contractual costs, opportunity costs.
v. Direct Intervention by the Shareholders-shareholders can intervene directly and
dictate to management how the business should be run. They can intervene in the
following ways
• Insist on a more independent board of directors.
• Making a recommendation on how the company should be run
• Making recommendations to the management on how the firm should be run.

vi. By sponsoring a proposal to be voted at the AGM even if the management would be
against the proposal

Shareholders and Creditors

In this relationship creditors are the principals and shareholders are the agents. Creditors lend
money to the company at a particular rate of interest depending on the riskiness of the firm as
perceived by creditors. However shareholders may influence on how these funds are to be
invested i.e they may dictate to management to invest in high risk return projects, if these
projects fail the creditors will share in the loss.
Cause of Conflicts between Shareholders and Creditors
• Through sale of assets that were offered as collateral to obtain the loan
• Borrowing additional debt capital where the additional debt may take priority over the
old debt
• Paying high dividends so that there is no retained earnings to repay the loan capital.

Solutions to the Conflict

➢ Restrictive Bond/Debt Covenant- setting up restrictive covenants to be incorporated in
the debt contract. Such covenants may restrict:
a) No disposal of assets without the permission of the lender.
b) No payment of dividends from retained earnings
c) Maintenance of a given level of liquidity indicated by the
amount of current assets in relation to current liabilities.
d) Restrictions on mergers and organizations
e) No borrowing of additional debt, before the current debt is
fully serviced/paid.
f) Management ability to make future decisions
➢ Threat of not granting any future credit- if creditors discover that the company is
misusing the current credit they can threaten not to grant any future credit.
➢ Demanding Security or Collateral- Creditors can demand security before granting
credit.

Shareholders and Auditors

In this relationship shareholders are the principals and auditors are the agents Shareholders
appoint auditors to monitor the performance of the management and certify the financial
statements issued by the management so as to establish if they give a true and fair view of the
state of affairs of the company on behalf of the shareholders. They act as watchdogs to ensure
that the financial statements prepared by the management reflect the true and fair view of the
financial performance and position of the firm. The auditors may prejudice the interest of the
shareholders thus causing agency problems in the following ways:
 a) Colluding with the management in performance of their duties whereby their
independence is compromised.
b) Demanding a very high audit fee (which reduces the profits of the firm) although there
is insignificant audit work due to the strong internal control system existing in the
firm.
c) Issuing reports which might be misleading the shareholders and the public and which
may lead to investment losses if investors rely on such misleading report to make
investment and commercial decisions.
d) Failure to exercise professional care and due diligence in performance of their audit
work hence failing to detect errors and frauds.

Solutions to the conflict

1. Firing: The auditors may be removed from office by the shareholders at the AGM.
2. Legal action: Shareholders can institute legal proceedings against the auditors
who issue misleading reports leading to investment losses.
3. Disciplinary Action by professional bodies e.g ICPAK.- this can lead to
withdrawal of their practicing certificates.

1.8 Suggestion for Further Reading

1. Weygandt, Jerry J., Kimmel, Paul D., & Kiseo, Donald E. (2010). Financial
accounting. New York: John Wiley & Sons.
2. Albrecht, W.S., Swain, M., Stice, E., & Stice, J. (2010). Financial accounting.
Florence, SC: Cengage Learning.
3. Stice, E., Stice, J., & Diamond, M. A. (2005). Financial accounting: Reporting &
analysis. Florence, SC:. Cengage Learning.