Introduction to the Agency Theory

1. Introduction to the Agency Theory Budi Purwanto Department of Management Bogor University of Agriculture

2. Corporations managed through principal-agent relationship Agency problem Agency costs Agency theory Introduction

3. The development of the theory • Principal-agent literature • Self-interest of individuals • Agency costs should minimized through Pareto-efficient contract • Mathematical approach • Game theory • Positive theory of agency • Self-interest of individuals • Agency costs should minimized through Pareto-efficient contract • Empirical approach

4. Agency Problems • The basic goal of financial management: to create stock-holder value • Agency relationships: 1. Stockholders versus managers 2. Stockholders versus creditors

5. Principal-agent relation An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent.

6. If you are the only employee, and only your money is invested in the business, would any agency problems exist? No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. You own 100 percent of the firm.

7. If you expanded and hired additional people to help you, might that give rise to agency problems? An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them.

8. If you needed additional capital to buy computer inventory or to develop software, might that lead to agency problems? Acquiring outside capital could lead to agency problems.

9. Would it matter if the new capital came in the form of an unsecured bank loan, a bank loan secured by your inventory of computers, or from new stockholders? Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors.

10. There are 2 potential agency conflicts: • Conflicts between stockholders and managers. • Conflicts between stockholders and creditors.

11. Would potential agency problems increase or decrease if you expanded business operations? Increase. You could not physically be at all locations at the same time. Consequently, you would have to delegate decision-making authority to others.

12. If you were a bank lending officer looking at the situation, what actions might make a loan feasible? Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenantsin debt agreements. They can also charge a higher than normal interest rate to compensate for risk.

13. As the founder-owner-president of the company, what actions might mitigate your agency problems if you expanded beyond your home campus? 1. Structuring compensation packages to attract and retain able managers whose interests are aligned with yours. (More…)

14. 2. Threat of firing. 3. Increase “monitoring” costs by making frequent visits to “off campus” locations.

15. Would going public in an IPO increase or decrease agency problems? By going public through an IPO, your firm would bring in new shareholders. This would increase agency problems, especially if you sell most of your stock and buy a yacht. You could minimize potential agency problems by staying on as CEO and running the company.

16. What kind of compensation program might you use to minimize agency problems? • “Reasonable” annual salary to meet living expenses • Cash (or stock) bonus • Options to buy stock or actual shares of stock to reward long-term performance • Tie bonus/options to EVA

17. Agency Cost – another equilibrium theory of optimal capital structure • Jensen and Meckling (1976) use agency cost to argue that the probably distribution of cash flow provided by the firm is not independent of its ownership structure and that this fact may be used to explain optimal leverage • There is an incentive problem associated with issuance of new debt (agency cost of debt) • There are agency costs associated with external equity • The agency cost of external equity may be reduced if the management and shareholder agree to hire independent auditor (Watts and Zimmerman, 1979)

18. Agency cost not be limited to costs associated with providing debt and equity capital • Titman (1984) suggest that agency costs are important for contracts (whether implied or explicit) between the firm and its customers or between the firm and its employees • Firm that produce durable goods will have lower demand for their product if their increase their probability of bankruptcy by carrying more debt • Firms that use a larger percentage of job-specific human capital will also tend to carry less debt, ceteris paribus.

19. References • Jensen, Michael C. and William H. Meckling. 1976. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, October, 1976, V. 3, No. 4, pp. 305-360. • Fama, Eugene F. 1980. Agency Problems and the Theory of the Firm. The Journal of Political Economy, Vol. 88, No. 2. (Apr., 1980), pp. 288-307. • Fama, Eugene F. and Michael C. Jensen. 1983. Agency Problems and Residual Claims. Journal of Law and Economics, Vol. 26, No. 2, Corporations and Private Property: A Conference. Sponsored by the Hoover Institution. (Jun., 1983), pp. 327-349. • Harveya, Campbell R. and Karl V. Linsc, and Andrew H. Roper. The effect of capital structure when expected agency costs are extreme. Journal of Financial Economics 74 (2004) 3–30.

20. Thank you!