Question

Jensen and Meckling (1976) refers to the costs that arise due to the use of an agent by a principal in an agency relationship as agency cost. These costs include (1) the costs of opportunistic behaviour by the agent (such as when the agent places his own self-interest over that of the principal’s), (2) the costs to the principal of monitoring the agent; and (3) the “bonding” costs incurred by the agent to induce the principal to rely on it. Nonetheless, the opportunistic behaviour of the agent may work in the favour of principal when the agent contracts with other parties such as debtholder. This phenomenon has been explained as the agency cost of debt (Kim and Sorenson, 1986). Furthermore, Coffee, Jackson, Mitts and Bishop (2018) extend the agency cost argument to the relationship between the different types of shareholders associated with modern corporations. Specifically, Coffee et al., (2018) find that there is the tendency for strong and powerful shareholders to exploit less powerful shareholders. These empirical evidences suggest that any investor may be susceptible to some form of exploitation as result of the agency relationship and its associated agency problem.

Critically examine the following scenarios and state with explanation;

Whether an investor has a high, medium or low level of agency cost

The type of agency cost likely to be assume an investor

The type of corporate governance mechanism which would be appropriate in addressing the type of agency cost

Note: the following scenarios are independent of each other.

SCENARIO ONE

ABC Ltd, an Australian based firm is a large manufacturing firms with 25 subsidiaries which operates from different part of the world. On 30th July 2018, Birim Equity fund acquired an additional 25% of shares of ABC Ltd resulting in its total shareholding of 48%. The Herald Sun in its business segment described the acquisition as one which makes Birim Equity a dominant shareholder. How would this situation affect agency cost for prospective investor if

Birim Equity is separated from management

Birim Equity is not separated from management

SCENARIO TWO

Michael Bloomberg, a recent graduate of La Trobe University received $0.5 million cash as his inheritance after the death of his father. Michael has decided to invest his wealth in a listed firm which characterised by many shareholders with each shareholder having a small amount of shares

SCENARIO THREE

Tori, a small-time investor, has decided to invest in Dada PLC. Dada PLC has a large bank loan on its books.

Please use the following papers to critically examine the scenarios:

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of financial economics, 3(4), 305-360.

Kim, W. S., & Sorensen, E. H. (1986). Evidence on the impact of the agency costs of debt on corporate debt policy. Journal of Financial and quantitative analysis, 21(2), 131-144.

Coffee, J. C., Jackson, R. J., Mitts, J., & Bishop, R. (2018). Activist Directors and Agency Costs: What Happens When an Activist Director Goes on the Board?

Required Length: 500 words excluding the references.

Marking criteria

Marks will be allocated to:

Clear and concise discussion of the key points

Relevance to the topic and evidence of wide reading/research

Presentation – format, spelling, vocabulary, readability

Appropriate referencing, including in-text referencing and a reference listStudents may follow either:

Harvard referencing style or ;

APA 6 referencing style

Answer 1

Agency relationship is a contract between two parties, Principal and Agents. Agents are engaged by Principal to perform some duties, these agents are also assigned some decision making authority on behalf of the principal. Example of such a relationship is that of one between stockholders and company management. Here stockholders who are the owners of the resources of the company are principal while management is the hired agent. Ideally agents should act in best interests of the principal but conflicts and issues arise when interests of the agents differ from those of the principal. These issues are termed as agency problems. Often high cost is incurred to keep these problems at bay, such costs are termed as agency costs. These include the following –

1. Cost incurred in monitoring the actions of the agents.

2. Cost incurred to create a bond with the agent

3. Residual cost or in other words the loss principal has to bear due to difference in interests.

In addition to bearing these costs the principal has to take appropriate steps to induce agents to act for the welfare of the principal.

In the three given scenario we evaluate the level of agency cost to be borne by the investors as well as point out its type. In addition to this we have to suggest a mechanism for addressing these costs.

Scenario 1

In the given scenario it is evident that Birim Equity fund has become dominant shareholder due to which it can exercise its influence to benefit itself. It can use company resources thereby adversely affecting the interest of minority shareholders. Here two types of agency problems will arise, one between shareholders and managers, another between dominant shareholders and minority owners. Prospective shareholder therefore would need to keep in mind that agency costs may arise for the following two reasons –

1. Managers making insufficient effort to benefit the owners.

2. Dominant shareholder utilizing company resources for its own benefit.

Level of agency cost to be incurred would depend on how great an influence the equity fund has on the management. In case Birim is separated from the management then the shareholders would simply have to bear agency cost of equity, which is the cost borne by shareholders to prevent management from taking inefficient decisions. In case however Birim gets closely associated with management then other shareholders will also have to monitor that company’s resources are not consumed by it. In such case therefore level of agency cost would be high.

In order to prevent the stated agency problems minority shareholders should ensure presence of independent directors on the board and ensure that they perform their fiduciary duties properly. These directors should also keep an eye on the auditors performance as well his reports.

Scenario 2

Bloomberg is investing in a listed company which doesn’t have any dominant shareholders. Here the agency relationship is between the company’s different shareholders and its management. Agency cost in this case would be low because the company is listed and is already under the scrutiny of SEC. Investors however would have to bear the agency cost of equity which would be incurred to prevent the management from acting inefficiently. Normally in case of listed companies auditors are hired to scrutinize company’s financial statements, in addition to this board of directors also keep a check on the actions of the management. The company can also make use of ESOPs to encourage company management to improve the value of the firm and benefit the shareholders.

Scenario 3

Dada PLC is a privately controlled company with high debt. Majority stockholders as well as debt holder both can hamper the interests of minority investors such as Tori. Debt holders can charge higher interest rates since the company is under heavy debt, they may also impose restrictive covenants due to which Tori’s interests may suffer. In addition to this the company is a private limited company therefore not under SEC scrutiny. Dominating shareholders therefore may misuse their position and use company’s resources without giving proportionate share to Tori. In such case due to high residual costs, agency cost from the point of view of Tori would be high. There is very little that Tori can do in this scenario since decisions of majority shareholders as well as controlling debt holders will prevail.