What is Agency Problem?
Agency problem is a situation in which agents of an organization (e.g. the management) use their authority for their own benefit rather than that of the principals (e.g. the shareholders). The agency problem also refers to simple disagreement between agents and principals.
An agency problem occurs when the interests of stockholders, the board of directors, and/or the management of the company are not perfectly aligned or when these entities conflict. In publicly held companies, there are a variety of individuals with an interest in the performance of the company. The managers and executives who run the company on a day-to-day basis, the shareholders who own stock, and the board of directors who oversee the company's business development all may have different aims or ideas of how the business can be run.
Executives of a corporation may, for example, be interested in achieving good long-term growth of the company. Since their performance is measured by how the company does in both the short term and the long run, the decisions they make are based on the goals of generating profit both now and in the future. This may mean they wish to engage in capital expenditures now to secure a possible benefit or gain in the future.
The board of directors may also have a difference of opinion from the shareholders or the executives, aiming to take the company in a different direction still. The board may have the power to remove a chief executive or manager from power, but the shareholders may disapprove of this decision. Conflicts can occur among all three entities, creating issues that are difficult to resolve.
Mechanism to resolve the conflict of interests between shareholders and managers:
Conflict of interest between the shareholders and managers can be resolved through the mechanism of agency costs and market forces that reward the managers for their good performance and punish them for poor performance. The performance of managers should be evaluated through the market price of shares. Higher the market price of the shares, better the performance of managers and vice versa. Some of the specific mechanisms to resolve the agency problem between managers and shareholders are briefly described below:
1. Managerial Compensation:
Managerial compensation refers to the incentive mechanism for the good performance of the management. Their objectives are to attract and retain able managers and to harmonize managerial actions with the interest of shareholders. Several measures are used to evaluate managers' performance. Some of the most common are sales, profit, current value of expected cash flows and value added.
2. Shareholder control and interference
Shareholders can influence the company's management in two ways. Firstly, they can influence management directly as to how the company should be managed. Secondly, any shareholder can make a proposal which is voted on at the annual general meeting (AGM).
3. Threat of dismissal
In the past it seldom happened that a senior manager or chief executive officer was dismissed by shareholders. The reason for this was possibly that the ownership of a great number of companies was dispersed, as well as the fact that the agency problem was only brought to the attention of shareholders (and management) over the past two decades.
4. Threat of take-overs
The threat of a take-over serves to monitor the actions of management. If the actions or decisions of management decrease the future earnings or value of shareholders, the share price usually decreases as well. In some instances, the company can become a take-over target. If the management of such a company is replaced, the move can benefit the shareholders. The threat of take-overs can thus serves as an external control mechanism which ensures that the decisions and actions of management maximize shareholders' wealth.
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