Posted: February 24th, 2022

Concepts of Agency Cost or Agency Problem

What is meant by an “agency cost” or “agency problem”? Do these interfere with shareholder wealth maximization? Why? What mechanisms minimize these costs/problems? Are executive compensation contracts effective in mitigating these costs/problems? Our textbook defines an agency problem as a “conflict between the goals of a firm’s owners and its managers” (Megginson & Smart, 2009). It then defines agency costs as dollar costs that arise because of this conflict.
In the corporate structure, stockholders are the owners of the firm, and they elect a board of directors to oversee the firm and help protect their investment. The board then hires the right corporate managers to run the firm with the goal of maximizing the wealth of the shareholders. In a vacuum, this is a perfect framework by which to run a corporation; however, the reality is that a corporation’s managers are influenced and driven both by the company’s goals and by their own personal goals.
Our textbook lists a few of those goals on page 25 as personal wealth, job security, lifestyle, prestige, and ‘perks’ (Megginson & Smart, 2009). These agency problems can directly interfere with the corporation’s goal of shareholder wealth maximization because of the costs that these problems create. For example, an executive might become so focused on his personal goals that he “takes his eye off the ball” of the company’s goals. In addition, the board may have to institute costly auditing or bonding measures to ensure the effectiveness of its managers, or protect the company from executive wrongdoing.

Our text lays out three broad ways that shareholders can try to mitigate these types of agency problems; they are: relying on market forces, structured executive compensation packages, and the auditing/bonding measures discussed above (Megginson & Smart, 2009). The “market forces” category is loosely defined as the pressure put on a business by the rest of the market and its competitors. This can manifest itself in the form of a hostile takeover, whereas another entity purchases a controlling interest in the firm with the goal of making a profit on that investment.
Generally, under-performing companies are the prime targets of hostile takeovers, so it makes sense that aligning shareholder and executive goals is a major way to avoid that. One popular way of aligning these goals is through the use of elaborate, structured compensation plans for executives which directly tie an executive’s salary to the performance of the company, usually and specifically its stock price (Megginson & Smart, 2009). These compensation plans have become the norm for American corporations, and their effectiveness in solving the agency problem is debatable.
On one hand, it should drive an executive to strive to maximize the shareholder wealth, and it also helps companies to attract and retain the best available managers. On the other hand, it serves to sometimes wildly inflate the compensation paid to these executives, either by corporations trying to stay competitive for the best talent, or through easily achievable goals and uncapped maximums. The structured plans, if done correctly, are an effective way to help insure the goal of wealth maximization, but they are also by definition agency costs.
Hence, agency problems are inherent to our American corporate system. Works Cited: Megginson, W. L. , & Smart, S. B. (2009). Introduction to Corporate Finance. Mason, OH: South-Western. Chapter 2 If you were a commercial credit analyst charged with the responsibility of making an accept/reject decision on a company’s loan request, with which financial statement would you be most concerned? Which financial statement is most likely to provide pertinent information about a company’s ability to repay its debt?
If I was in charge of approving or denying a loan for a company, I would be most concerned with that company’s last few Income Statements. An Income Statement provides the details of a firm’s business performance over a set period of time, and it shows all sources of revenues and expenses for a business. Analysis of an Income Statement will clearly show the health of a company’s business operations. This question is misleading though, because any loan approval authority would obviously also be concerned with a company’s Balance Sheet, Statement of Cash Flows, and Notes to Financial Statements documents as well.
Through a thorough review of all the firm’s statements, an analyst can calculate the most important ratios to determine the credit-worthiness of a prospective loan customer. The Statement of Cash Flows, in particular, is the single best document for determining if a firm has the required liquidity to repay a new obligation. This is achieved by calculating important ratios such as the OCF and the FCF. However, since the Statement of Cash Flows is comprised entirely of data presented on other financial statements, it did not rise to the level of “most concerned with” for the purpose of answering this question.