Question

what is the agency relationship between shareholders (or owners) and managers? What are agency costs here in relationship? What are the ways agency costs can be reduced?

Answer 1

The agency view of the corporation posits that the decision rights (control) of the corporation are entrusted to the manager to act in shareholders’ and other stakeholders ‘ interests. Partly as a result of this separation, corporate governance mechanisms include a system of controls intended to help align managers’ incentives with those of shareholders and other stakeholders.

The deviation from the principal ‘s interest by the agent is called ‘agency costs. ‘ Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives of the managers and other stakeholders. Three parties key to the functioning of the corporation are the managers, shareholders, and bondholders. These three parties have different interests and asymmetric information, such that the principals cannot directly ensure that the agents are always acting in its (the principals’) best interests.

While managers control the corporation and make strategic decisions, shareholders are owners, and bondholders are creditors. While all three parties have an interest, whether direct or indirect, in the financial performance of the corporation, each of the three parties has different rights and rewards, for example voting rights and forms of financial return. Shareholders, managers, and bondholders have different objectives. For example, stockholders have an incentive to take riskier projects than bondholders do, as bondholders are more interested in strategies that will increase the chances of getting their investment back. Shareholders also prefer that the company pay more out in dividends than bondholders would like. Managers may also be shareholders and reap the profits of more risky strategies or may prefer risk-averse empire-building projects

Agency cost can be reduced by introducing monitory techniques in the organization. Such techniques include establishing budgets, following proper accounting procedures, getting approvals, etc. These techniques can eliminate or put a limit on the expenditures.