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Corporate Finance
Corporation and the Agency Problems
Objectives
• What are agency problems? What are their types and what causes
them?
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Corporation and the Agency
Problems
Agency Problems
Agency Problems
• One of the major characteristic of a corporation is the separation
between ownership and control.
• This characteristic of a corporation is instrumental in inducing
managers (who possess the control) to place their personal
agenda ahead of the goals of shareholders. As a result, managers
do not always maximize the shareholders’ wealth.
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Agency Problems
• Whenever, managers place their personal agenda ahead of the
goals of shareholders, firms experience agency problems.
Agency Problems
• Some of the agency problems that can hurt shareholders are as
follows:
• Reduced Effort: Finding and implementing value-enhancing projects can
be a high-effort activity. Managers may not be willing to expend this effort.
• Perks: Managers are tempted to spend wastefully on perks (such as
upscale office accommodations, meetings scheduled at luxury resorts,
private jets). Spending resources on these perks destroy the value of
corporations.
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Agency Problems
• Empire Building: Other things equal, managers prefer to run large
businesses rather than small ones. Getting from small to large may not be
a value-enhancing activity.
• Entrenched Investments: Managers prefer to invest in the projects that
require or reward the skills possessed by them. By doing so, they may
reject the projects that increase the value of corporation and accept
inferior projects.
Agency Problems
• Overinvestment: Managers of firms with excess cash are tempted to
overinvest in projects. Overinvestment, usually, reduce the value of
corporations. Entrenched investments and empire building are special
forms of overinvestment.
• Insufficient Disinvestment: Sometimes value is added by divesting
(selling off a factory or a product line or closing down a loss-making
business). Managers are reluctant to disinvest. The reluctance to disinvest
can reduce value.
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Agency Problems
• Risk Taking: Managers may shy away from attractive, but risky, projects
because they are worried about the safety of their jobs.
Corporation and the Agency
Problems
Types of Agency Problems
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Types of Agency Problems
• In finance literature, agency problem is not only limited to the
principal (shareholders) and the agent (managers). In fact, it goes
beyond and covers other parties, such as creditors, major
shareholders and minority shareholders.
Types of Agency Problems
• Finance research has categorized the agency problem into the
following three types.
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Types of Agency Problems
Type I: Principal-Agent Problem
• The managers are hired by shareholders with a hope that they will
work for the benefit of shareholders. However, managers are more
interested in maximizing their own benefits.
• The argument underlying self-serving behavior of managers is
based on the assumption that humans take actions to maximize
their own benefits.
Types of Agency Problems
Type I: Principal-Agent Problem
• The misalignment of interests between shareholders and
managers lead to the conflict, which is known as principal–agent
conflict. The conflict gives rise to Type I agency problems.
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Types of Agency Problems
Example 1
• Give an example of the agency problems that exist between
shareholders and managers?
Types of Agency Problems
Example 1
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Types of Agency Problems
Type II: Principal-Principal Problem
• The underlying assumption for this type of agency problem is the
conflict of interest between the majority and minority
shareholders.
• Majority shareholders are termed as a person or a group of
persons that hold the majority of the shares of a firm, while
minority shareholders are those persons that hold a very less
portion of the firm’s share.
Types of Agency Problems
Type II: Principal-Principal Problem
• The majority shareholders (or blockholders) have higher voting
power. Therefore, they are able to take decisions that can benefit
them at the expense of minority shareholders.
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Types of Agency Problems
Type II: Principal-Principal Problem
• This kind of agency problem prevails in a country or a company,
where ownership is concentrated in the hands of few persons or
within the family.
• Under these type of agency problems, minority shareholders find
it difficult to protect their interests or wealth.
Types of Agency Problems
Example 2
• Give an example of the agency problems that exist between major
shareholders and minor shareholders?
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Types of Agency Problems
Example 2
Types of Agency Problems
Type III: Principal-Creditor Problem
• The conflict between owners/managers and creditors arise due to
the projects undertaken by firms.
• Managers try to invest in the risky projects, where they expect
higher return. The risk involved in the projects raises the cost of
the finance and decreases the value of outstanding debt, which
affects the creditors.
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Types of Agency Problems
Type III: Principal-Creditor Problem
• If the project is successful, the shareholders will enjoy huge
profits, while the benefit of the creditors is limited as they get only
a fixed rate of interest.
• On the other hand, if the project fails, the creditors will be forced
to share some of the losses (assuming collateral might not be
enough to compensate for the losses).
Corporation and the Agency
Problems
Causes of Agency Problems
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Causes of Agency Problems
• Some of the causes of agency problems are summarized in the
following table.
Causes of Agency
Problems
Explanation
Type of Agency
Problems
Separation of
The separation of ownership from control leads to the
Ownership from Control loss of proper monitoring by the owners on the
managers. As a result, managers use the business
property for their private purpose to maximize their
welfare.
Type-I
Risk Preference
Type-I and TypeIII
The parties involved in the organizations may have
different risk preferences. This conflict
arises between owners and managers and
owners and creditors.
Causes of Agency Problems
Causes of Agency
Problem
Explanation
Type of Agency
Problem
Moral Hazard
Moral hazard is the risk that a party has not entered
Type-I
into a contract in good faith or has provided misleading
information about it self.
Information Asymmetry
Managers look after the firm and are aware about all
the information related to the business, while owners
depend upon the managers to get the information. So
the information may not reach to the owners exactly in
the same manner.
Type-I
Decision Making
Mostly, the majority shareholders take the decision in
the firms due to high voting rights, while the minority
shareholders only follow it.
Type-II
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Causes of Agency Problems
Causes of Agency
Problem
Explanation
Type of Agency
Problem
Limited Earnings
Both the managers and creditors of the firm are the
significant stakeholders of the firm, but they have
limited earnings. That is, managers are concerned for
their compensation, while creditors look for the
interest amount only.
Type-I and Type-III
Duration of Involvement
The managers work for the organizations for a limited
period, whereas the owners are the inseparable part of
the firms. Hence, the agents try to maximize their
benefit within their limited stay and then move to
another firm.
Type-I
Corporation and the Agency
Problems
Agency Costs
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Agency Costs
• The agency costs are the internal costs that occur due to
misalignment of interest between shareholders and managers.
Following are some of the examples of these costs:
• Costs incurred while picking up suitable managers
• Costs incurred while collecting information to analyze managerial
performance
• Cost incurred while monitoring managerial actions
• Cost incurred due to inefficient decisions of the managers
Agency Costs
• The literature describes the agency cost as the aggregate of the
monitoring cost, bonding cost and residual loss.
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Agency Costs
Monitoring Costs
• Monitoring cost represent the cost associated with the monitoring
and assessing of the performance of managers.
• The expenditures covered under the monitoring cost may include
the expenses, such as the payments for monitoring and the
payments for compensating and evaluating manager’s behavior.
For example, shareholders appoint boards to monitor the
managers. Hence, the cost of maintaining a board is considered as
a monitoring cost.
Agency Costs
Bonding Costs
• In some situations, agents (managers) set up structures that will
make them act in the best interests of shareholders. The cost of
establishing and adhering to these systems are known as bonding
costs.
• In other words, the bonding costs are the resources needed by the
agent to guarantee the principal that he will not take any harmful
action from the principal’s point of view.
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Agency Costs
Bonding Costs
• The optimal bonding contract should aim to entice managers into
making all decisions that are in the best interests of shareholders.
• Since managers cannot be made to do everything that
shareholders would wish, bonding provides a mechanism of
making managers do some of the things that shareholders would
like.
Agency Costs
Bonding Costs
• These costs are borne by the agent, but are not always financial.
Some of the examples of bonding costs are the following:
• Cost of additional information disclosure
• Time and effort expended in producing and providing voluntary quarterly
accounting reports
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Agency Costs
Example 1
• Can we consider capital structure decision as a bonding cost?
Agency Costs
Example 1
• Capital structure can be considered as an example of bonding cost.
By issuing debt, management creates contractual obligations to
pay out future cash flows.
• Debt financing can also help create external capital market
monitoring which incentivizes managers’ avoidance of personal
utility maximization and increases value maximizing strategies for
shareholders.
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Agency Costs
Residual Loss
• Despite monitoring and bonding, the interest of managers and
shareholders are still unlikely to be fully aligned. Therefore, there
are still agency losses arising from conflicts of interest. These are
known as residual loss.
Agency Costs
Residual Loss
• They arise because the cost of fully enforcing principal-agent
contracts would far outweigh the benefits derived from doing so.
• Since managerial actions are unobservable ex-ante, to fully
contract for every state of nature is impractical. The result of this
is a residual loss, which may represent a trade-off between overly
constraining management and enforcing contractual mechanisms
designed to reduce agency problems.
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Corporation and the Agency
Problems
Proxies of Agency Costs/Problems
Proxies of Agency Costs/Problems
• Agency costs/problems are reflected in various firm-specific
characteristics. These characteristics can be used as a proxy to
represent various dimensions of agency costs.
• Some of the characteristics that can be used as a proxy for agency
costs are shown on the next slide.
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Proxies of Agency Costs/Problems
Corporation and the Agency
Problems
References
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References
• Brealey, R.A., Myers, S.C., and Allen, F., (2016). Principles of
Corporate Finance (Chapter 1). 12th Edition, McGraw-Hill.
References
• Agrawal, A. and Knoeber, C.R., (1996). Firm Performance and
Mechanisms to Control Agency Problems between Managers and
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• Panda, B. and Leepsa, N.M., (2017). Agency Theory: Review of
Theory and Evidence on Problems and Perspectives. Indian
Journal of Corporate Governance, 10(1), pp. 74-95.
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References
• Ang, J.S., Cole, R.A., and Lin, J.W., (2000). Agency Cost and
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• Faccio, M., Lang, L.H.P., and Young, L., (2001). Dividends and
Expropriation. American Economic Review, 91(1), pp. 54–78.
References
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Entrenchment on Agency Costs: An Empirical Investigation using
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References
• Henry, D., (2010). Agency Costs, Ownership Structure and
Corporate Governance Compliance: A Private Contracting
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• Li, H. and Cui, L., (2003). Empirical Study of Capital Structure on
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References
• McKnight, P.J. and Weir, C., (2009). Agency Costs, Corporate
Governance Mechanisms and Ownership Structure in Large UK
Publicly Quoted Companies: A Panel Data Analysis. Quarterly
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• Rashid, A., (2013). CEO Duality and Agency Cost: Evidence from
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989–1008.
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References
• Rashid, A., (2016). Managerial Ownership and Agency Cost:
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References
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• Wellalage, N. and Locke, S., (2012). An Empirical Investigation of
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References
• Wellalage, N. and Locke, S.,(2011). Agency Costs, Ownership
Structure and Corporate Governance Mechanisms: A Case Study in
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References
• Zajac, E.J. and Westphal, J.D., (1994). The Costs and Benefits of
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