Question

After reading the following case, please answer the following questions:

1. Why does agency problem arise?

2. What is the cost of agency problem?

3. How to minimize the agency problem?

CASE STUDY ON AGENCY PROBLEM ABC

Company started operations in early 1970. The company produces specialized items for manufacturing cars. Most of the raw materials used are imported from Brazil because the cost is low and the labor is very cheap. The CEO for ABC Company, Mr. Rodriguez, makes every attempt to keep the cost at the lowest. From 1970 to 2000 net income has increased at a rate of at least 25% per year. There are around 20,000 shareholders that hold ABC Company shares. Shareholders are very happy with the company’s performance. Mr. Rodriguez always held a meeting with Board of Directors to inform them of any decision involve in the company. As such the BOD is very happy with the company performance and Mr. Rodriguez managing style. Every year, the staff received cash bonus of around 2 to 3 times of their salary and Mr. Rodriguez received many incentives from the company including cars, houses and cash. However, at the end of 2001, the cost of raw material increases because of the attack of SARS virus in Brazil. The sales for the year were also reduced. By September 2001, Mr. Rodriguez held an emergency meeting with all the staffs. It is estimated that the income for the year will be reduced. By January 2002, after the preparation of the financial statements, net income showed a decreased of around 45% from last year. Mr. Rodriguez demanded the treasures and the controller to do something with the figures. During the BOD meeting in April 2002, the company announced a 15%increase in the income and declared a dividend of around 5% higher than last year. The shareholders reacted positively to the announcement and started buying more shares of the company. For the next five years, the company continue to decrease in income but providing a good news to the shareholders and giving shareholders higher profit. In 2008, the BOD requested for the company to change the auditor for the company. After the auditing process, the new auditor revealed that the company is in the state of bankruptcy and there are zero balance cash in the bank account. One month after that the company was forced to closed down. Shareholder were surprised with the announcement and lost all their money. The employees lost their job and many creditors couldn’t claim their money. Shareholders are currently suing Mr. Rodriguez and the company for their losses.

Answer 1

1) The agency problem arises when the management of the company who are entrusted to run the company on behalf of the shareholders act to maximize benefits for themselves instead of working towards the welfare of the shareholders. In this case, Mr Rodriguez acted to show a false picture of the company's financial state because showing the true picture would have meant that his salaries and bonuses would have been curtailed. Hence he acted in his self interest and jeopardised the economic interests of the shareholders and the investors.

2) The cost of the agency problem is huge and it results in ultimate closing down of the business if the agency problem is not addressed in advance. It ultimately leads to erosion of wealth for the shareholders, write-offs for the corporate creditors and also loss of employments for the employees.

3) The agency problem could be minimized by aligning the long term performance of the company with the executive compensation. Also compensation should include stock options and share bonuses as this will ensure that management works to maximize the enterprise value and the executives also gain through rise in the value of the stocks rather than focussing on short term growth or fudging the financial statements to get cash bonuses.