Question

Detailed Report :

1. Discuss agency relationship, agency problems and agency cost in an organisation
2. Discuss the possible solution to the agency problems faced with organisation

Answer 1

QUESTION 1.  AGENCY PROBLEM

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth. In an orginisation's point of view its its conflict of interest between management and shareholders.

AGENCY RELATIONSHIP

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. Agents are commonly engaged by principals due to different skill levels, different employment positions or restrictions on time and access.

The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way.

Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal's or client's best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court's assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.

This type of problem can exist anywhere whether it is a company, club, church or even government institutions. The three types of agency problems are stockholders v/s management, stockholders v/s bondholders/ creditors, and stockholders v/s other stakeholders like employees, customers, community groups, etc.

Every organization has its own set of long-term and short-term goals and objectives that it wishes to achieve in a pre-determined period of time. In this context, it must also be noted that the goals of the management may not necessarily align with that of the stockholders.

The management of an organization may have goals that are most likely derived with the motive of maximizing their personal benefits while on the other hand, the stockholders of an organization are most likely interested in their wealth maximization. This contrast between the goals and objectives of the management and stockholders of an organization may often become a basis for agency problems. Precisely speaking there are three types which are discussed below-

Stockholders vs Management – Large companies may have a huge number of equity holders. It is always crucial for an organization to separate the management from ownership since there is no reason for them to form a part of management. Segregating ownership from management has endless advantages as it does not have any implications upon the regular business operations and the company will hire professionals for managing the key operations of the same. But hiring outsiders may become troublesome for stakeholders. The managers hired may take unjust decisions and might even misuse the shareholders’ money and this can be a reason for the conflict of interests between the two and hence, agency problems.

Stockholders v/s Creditors – the stockholders might pick up risky projects for making more profits and this increased risk might elevate the required ROR on the company’s debt and hence, the overall value of the pending debts might fall. If the project sinks, the bondholders will supposedly have to participate in losses and this can result in agency problems with the stockholders and the creditors.

Stockholders v/s other Stakeholders – The stakeholders of a company may have a conflict of interests with other stakeholders like customers, employees, society, and communities. For example, the employees might be asking for a hike in their salaries which if rejected by the stakeholders then there are probabilities of agency problems to take place.

AGENCY COST

Agency Cost is commonly referred to as the disagreements between shareholders and managers of the company and the expenses incurred to resolve this disagreement and maintain a harmonious relationship. This form of disagreement becomes obvious as the principals or the shareholders want the managers of the company to run it to maximize the shareholders’ value, while, on the other hand, the managers want to operate in a way to maximize the wealth. This might even affect the market value of the company. The expenses to handle these opposing interests are termed agency costs.

Agency costs can be broadly classified into two types: Direct and Indirect Agency costs.

1. Direct Agency Cost

• Monitoring Costs: When the activities of the management of the company are aligned to the benefits of the shareholders and these restrict the activities of the management. The cost of maintaining the board of directors therefore to a certain extent is also a part of the monitoring costs. Other examples of the monitoring costs are the employee stock options plan available for the employees of a company.
• Bonding Costs: Contractual obligations are entered between the company and the agent. A manager continues to stay with a company even after it is acquired, who might forego the employment opportunities.
• Residual Losses: In case the monitoring bonding costs are not enough to diverge the principal and agent interests, additional costs are incurred which are called the residual costs.

2. Indirect Agency Cost

The indirect agency costs are those that refer to the expenses incurred due to the opportunity lost. For example, there is a project that the management can undertake but might result in the termination of their jobs. However, the shareholders of the company are of the opinion that if the company undertakes the project it will improve the shareholders’ values and if the management rejects the project it will have to face a huge loss in terms of shareholders’ stake. Since this expense is not directly quantifiable but affects the interests of the management and shareholders, it becomes a part of the indirect agency costs.

The most common method to handle the agency costs involved in a company is by way of implementing incentive scheme, which can be of two types: financial and non-financial incentives scheme.

1. Financial Incentives Scheme

Financial incentives help the agents by motivating them so that they can act for the interest of the company and its benefits. The management receives such incentives when they perform well on a project or achieves the required goals. Certain examples of the financial incentives scheme are :

• Profit-Sharing Scheme: The management becomes eligible to receive a certain percentage of the company’s profits as a part of the incentive scheme.
• Employee Stock Options: A pre-determined number of shares are available to be bought by the employees at a price which is usually lower than the market.

2. Non-financial Incentives Scheme

This scheme is less prevalent than the financial incentives scheme. These are less effective to reduce the agency costs when compared to the financial incentives scheme. Some of the common examples are :

• Non – financial rewards and recognition from peers and colleagues.
• Corporate services and added benefits.
• Better workspace.
• Better or improved opportunities.

QUESTION 2

Controlling of the Agency Problem

In order to prevent the managers to abuse their position and power and protect their interests, the stockholders

may use several different mechanisms. In the text that follows, the measures are divided into two groups first and

then analyzed as such:

a. Internal measures:

 Internal audit;

To secure the continuity and the development of the company, the internal audit is of the great importance to bemade. It helps to evaluate the efficiency of the company, to detect and stop the eventually inefficient operationsas well as to protect the assets and the capital.

 Change in the salaries and payments of the managers;

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.

 Concentrate ownership;

Another established practice is to offer the managers to buy shares and become owners themselves. This is theway of aligning the interests of the managers and the shareholders-long-term development, continuity andincreasing the value of the shares.concentrated ownership is an effective way to prevent the agency problem. According to them, managerial ownership share increases, their interest aligned with the shareholders interest, so they will act in a way that will increase the shareholder value

 Good corporate governance/manage

A good system of corporate governance is of great importance for an efficient control of the companies, for the enhancement of their performances, as well as for a better approach and availability of the external financing. Corporate governance is a term that regards to the relations and roles of each and every party involved as interested in the company.corporate governance means standardization of the processes, the procedures and the behavior of the companies. The principles of the corporate governance are as follows: responsibility, transparency and control within the decision making process, as well as reporting about the daily work of the company.

corporate governance as the collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stockholders The level of alignment of the interests of the interested parties within the company shows how good the corporate governance is. In the most cases there are a large number of involved and interested parties such as: shareholders, board of directors, board of managers, the managers, the government, the employees, the clients, the suppliers, the regulation officers, the media, the investors etc.

b) External measures:

It is essential to obey home and international standards and rules of work, in order for a company to grow and develop. These standards and rules can help controlling the work of the managers, together with prevention of the agency problem.

 External audit;

One of the measures taken to control the work of the company and prevent the agency problem is an effective external control of the work of the managers. The most effective way in this situation is to engage external audits who would periodically value the reality and objectivity of the company’s financial reports. Precise financial reporting is critical to ascertaining that the results are stated fairly and the management has not manipulated results for personal gain.

The audit reports are delivered to the shareholders, the managers, the employees, and to the ones who are involved at the market in order to use them as a part of the valuation of the company.

 Market of capital;

Market price of the shares of a company, according to which the company is valuated, is a signal of a successful work of the company. If the company is governed by a manager whose decisions make the company less efficient, it can lead to a situation when the shareholders would sell their shares. As big the offer of shares is, as lower the price gets, which should be a signal enough for the members of the board of directors that some changes within the managerial department have to be made. Nevertheless, it is very important to point out that in situation like the previously mentioned one, firstly some analysis should be made, meaning whether the lower price comes as a result of bad managing or as a result of the change of some external factors

 Law/legal frame.

The legal frame of the corporate governance is made by

- Trade Companies’ Law;

- The Law on Securities and Exchange;

- The Law on takeover of joint stock companies;

- Bankruptcy Law;

- Corporate Governance Code;

- Rules for quotation the Macedonian Stock Exchange.

Therefore, in order to overcome or even prevent this problem, it is necessary to control the work of the managers constantly and to make sure that the company works in accordance with the laws and the international rules in financing.

The agency problem arises when there is discrepancy between the management and shareholders rest rather in the shareholders’ interest. In this case, the management is acting in order to maximize personal wealth. But whenever there is a problem there is a solution for it. The various research, point out that there is not a single ideal solution that can help in preventing and solving the agency problem. In this paper we classified the measures into two groups: internal and external measures. Within the internal ones we analyzed the following measures: internal audit, managerial payments, concentrate ownership and good corporative governance. External audit, capital market and legislation are the external factors that we analyzed. The combination of the stated internal and external measures, as well as, the implementation of other similar measures can deliver the desired results in addressing the agency problem.