Introduction of Agency Theory

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  • Topic: Principal-agent problem, Agency cost, Asymmetric information
  • Pages : 5 (1421 words )
  • Download(s) : 730
  • Published : June 21, 2012
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1.0 Introduction of Agency Theory

The specific definition of the theory based on the sources investorword.com and investopedia.com defined that the agency theory is a theory explaining the relationship between principals such as shareholders and agents. It is essentially involves the cost and way of resolving the conflicts between the principals and agents and change the something slightly to the correct position and decision related to the two group of conflict. Thus, the main objective of agency theory is to explain how contracting parties design contracts to minimize the costs associated with such problems. Thefreedictionary.com defined agency theory seeks to explain the relationship in order to recommend the appropriate incentives for both parties to behave the same way, or more specifically, for the agent to have the incentive to follow principal’s direction. Jensen and Meckling (1976) defined managers of the company as the ‘agents’ and the shareholders as the ‘principal’ based on their analysis. In other words, the shareholder, who is the owner or principal, delegates day to day decision making in the company directors, who are the shareholder’s ‘agents’.

The theory is face and attempt to deal with specific problem; first the goals of the principal and agent are not in conflicted. Second, that the principal and agent reconcile different tolerance of risk. In addition, the primary agency relationships in business are those (1) between stockholders and managers and (2) between debt holders and stockholders. Agency theory is concerned with so-called agency conflicts, or conflicts of interest between agents and principals.

The agency relationship can have a number of disadvantages relating to the opportunism or self interest of the agent: for example, the agent may not act in the best interests of the principal, or the agent may act only partially in the best interests of the principal. There can be a number of dimension to this including, for example, the agents misusing his power for pecuniary or other advantage, and the agent not taking appropriate risks in pursuance of the principal’s interests because he (the agent) views those risk as not being appropriate. There is also the problem of information asymmetry whereby the principal and the agent have access to different levels of information, in practice; this means that the principal is at a disadvantage because the agent will have more information.

2.0 Issues on Agency
There are several issues arise relating to agency. One particularly importance issue is , at what risk level will both debt holders ,manager ,and ultimately shareholder benefit maximally from investments undertaken by the company. Thus ,a brilliant decision need to be made in satisfying all parties if not at least one party will be scarified for the best interest of other parties. There are three types of problems that are associated with agency costs of debt:

I. Incentives to take large risks,
I. Incentive toward underinvestment, and
II. Milking the property,

2.1 Incentives to take large risks
As a firm approaches bankruptcy, management might take big risks. These risks have potentially large payoffs that might help the firm avoid bankruptcy. On the other hand, they may be long shots that actually push the firm into bankruptcy if they fail.

2.2 Incentive toward underinvestment
Investment by firms with a high probability of bankruptcy often benefits bondholders at the stockholder’s expense.

2.3 Milking the property
Milking the property occurs when management pays out extra dividends during times of financial distress. Give shareholders cash that might otherwise be granted to bondholders during bankruptcy proceedings.

The second importance issue relating to agency is “why companies pay dividend?” there are based several studies and opinion. According to Rozeff(1982) dividend payment are part of monitoring device which can reduce the agency cost....
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