Question

Explain in details the agency problem?

Answer 1

The Agency relationship arises when a principal hires an agent to represent their interest.Stockholders (principals) hire managers (agents) to run a company.The agency problem is defined by a situation in which there is a conflict of interest between a principal and agent.Agency cost is simply the cost of the conflict of interest. For example, if owners want to make a large risky investment in order to harvest long-term profits, managers may object because their short-term objectives are put at risk.If managers prevail, any foregone long-term cash flow is the agency cost.

Direct agency costs: compensation and perquisites for management. Managerial compensationcan be used to encourage managers to act in the best interest of stockholders. One commonly cited tool is stock options. The idea is that if management has an ownership interest in the firm,they will be more likely to try to maximize owner wealth.

Indirect agency costs: cost of monitoring and sub-optimal decisions.Stockholders technically have control of the firm, and dissatisfied shareholders can oust management via proxy fights, takeovers (e.g., Carl Icahn), etc. However, this is easier said than done. Staggered elections for board members often make it difficult to remove the board that appoints management. Poison pills and other anti-takeover mechanisms make hostile takeovers difficult to accomplish. Further, the cost of a proxy fight can be prohibitive, with the 2002HP/Compaq battle costing over $100 million.Stakeholders:Stakeholders are other groups, besides stockholders, that have a vested interest in the firm and potentially have claims on the firm’s cash flows. Stakeholders can include creditors, employees, customers, and the government.