Question

1. What is meant by an agency cost or agency problem as it relates to corporate finance? Name and discuss any two mechanisms Boards of Directors use to control or minimise agency costs or the agency problem?

Answer 1

Agency problem refers to the conflict of interests between a company’s owners or shareholders and the company’s management. It mainly occurs when managers have a goal other than the wealth maximization of the shareholders. In the agency problem, managers work for their own advancement, rather than the interest of the shareholders.

Agency cost arises due to the conflicts of interest between the managers and the stockholders of the company.

Measures that can be used for resolving the agency problems are given below-

1) Full transparency: Full transparency helps in filling the gap of knowledge that occurs due to the disparity in knowledge between the principal (Shareholder) and agent (Managers). If there is transparency in the actions of the executives then there will be a less chance of occurring agency problems.

2) Restriction’s on the agent’s powers or capabilities: Giving too much power to the agent may result in agency problems so in order to reduce the chances of agency problems agent’s power should be restricted so that they will not able to make poor choices on behalf of the principal. For example, most successful governments practice a regular check that tempers the power of an entity or one individual, to keep the corruption at a minimum level, the same principles can be enforced in the business in order to limit the power of agent.