Explain in details the agency problem

Agency problem

Agency problem also known as agency costs occurs in a two-party relationship (principal/agent) where the agent is expected to act or make decisions for the good of the principal.

For example in a corporate the relationship between the management and shareholders. The management is expected to make decisions that will maximize shareholders interest. The problem arises when the two parties have different interests. In the example above the manager may opt to make his own wealth and not act in the company’s best interest which could be maximizing company’s market value.

Examples of agency relationship in finance

Managers/stockholders

Managers/Creditors

Causes of conflicts between managers and stockholders may include;

Remuneration - low remunerations or fixed salaries despite increased profit margins.

Differences in risk profile - stockholders may prefer high-risk return investments contrary to the managers. When high-risk investment go bad the manager risks job loss

Manipulation of accounting systems - to reflect high profits.

Unnecessary perks management award themselves.

Solution to these problems include threat for firing in case of poor performance, shareholders may also threaten to sell the company, remuneration based on performance, incurring agency costs-these are costs incurred while hiring external auditors, setting a control system, legal costs for employment letters and contracts.

Agency problem may be reduced by motivating the manager to act for the companies best interest by offering incentives