Question

Q.3 In your own words explain how agency theory and corporate governance are related. Provide examples of companies that experienced problems in corporate governance answer with refrences

Answer 1

Agency theory is used to understand the relationship between principals and agents. The agent represents the principal in particular business transactions and is expected to represent the best interests of the principal without any self interest. The different interests of principal and agent may become a reason for conflict, some agents may not perfectly act in the principal's best interests. The resulting miscommunication and disagreement may result in so many problems and conflict within companies. Incompatible desires may drive a wedge between each stakeholders and cause inefficiencies and financial losses. This leads to the problems between principal and agent.

The problems between principal and agent occurs when the interests of a principal and agent come into conflict. Companies should find out a remedy to minimize these situations through solid corporate policies. These conflicts present normally ethical individuals with opportunities for moral hazard. Incentives may be used to redirect the behavior of the agent to realign these interests with the principal's interests.

Corporate governance can be used to change the rules under which the agent operates and restore the principal's interests. The principal should be aware of the knowledge of agent on the principal’s interests. Agents must be given incentives to encourage them to act in union with the principal's interests. Agency theory is used to design these incentives appropriately by considering what interests motivate the agent to act. Incentives encouraging the wrong behavior must be removed, and rules discouraging moral hazard must be in place. Understanding the mechanisms that create problems helps businesses develop better corporate policies.

Corporate management should act in the best interest of a company's stakeholders, especially the shareholders who own equity but have no direct voice in the company. The agency theory of corporate governance is quite simple, at least on the surface. It states that corporate executives have a moral and financial responsibility to act in the best interests of the parties they serve, specifically the shareholders.