An agency relationship is a contract under which one or more people hire another person to perform some service and delegate decision making authority to that agent. Within the financial management framework, agency relationship exists 1) between stockholders and managers, and 2)between stockholders and creditors.
A potential conflict of interest that can arise between 1) stockholders and managers and 2) stockholders and creditors is called agency problem.
1) Stockholders versus managers
Stockholders are the real owners of the corporation. There are large number of stockholders in a big corporation and they stay at far distant places inside and outside the country. In this condition, it is almost impossible to participate all the stockholders in regular business activities. To perform regular business activities, a management team is formed by the stockholders. Therefore, managers are the agents of the stockholders. There is principal-agent relationship between stockholders and managers. managers are supposed to work in the best interest of the stockholders. But managers of a large corporation have a great deal of autonomy, so they may not work for the stockholders' wealth maximization. Some have argued that the managers of a large and well established corporation can work to provide just a fair and reasonable rate of return and then the remainder of the resources and efforts may be mobilized to fulfil their life style at the cost of stockholders. Their main concern is present benefit and long run survival. They do not take risky ventures which may provide higher rate of return to stockholders. They emphasize only those projects that generate moderate level of profit. One reason of not taking risky venture is that managers do not receive a fair share of compensation out of the value they generate for the risk they take.
Another reason to avoid high risk is that the impact of negative results to management is more serious than stockholders. The risk of managers can't be diversified as the risk of stockholders. Their managerial skill is limited to one company. If things go wrong, they are responsible and can lose their jobs. On the other hand, the risk of stockholders can be well diversified by investing their fund making a portfolio of different stocks of different business firms. If a business firm goes into loss, the impact of this loss is not so serious to stockholders. it can be compensated from the profit of another business firm in which they have invested their funds. Thus, there is conflict in the interest of stockholders and managers. Such type of agency problems can be solved in the following ways:
- Provision of cash kind incentives to managers,
- Provision of stock option and stock bonus,
- Limiting managerial autonomy,
- Setting up a monitoring unit,
- Reorganization of the managerial structure in such a way that the actions of managers are automatically verified,
- Threat of takeover,
- Threat of firing,
- Competition, and
- Fear of career damage.
A potential conflict of interest that can arise between 1) stockholders and managers and 2) stockholders and creditors is called agency problem.
1) Stockholders versus managers
Stockholders are the real owners of the corporation. There are large number of stockholders in a big corporation and they stay at far distant places inside and outside the country. In this condition, it is almost impossible to participate all the stockholders in regular business activities. To perform regular business activities, a management team is formed by the stockholders. Therefore, managers are the agents of the stockholders. There is principal-agent relationship between stockholders and managers. managers are supposed to work in the best interest of the stockholders. But managers of a large corporation have a great deal of autonomy, so they may not work for the stockholders' wealth maximization. Some have argued that the managers of a large and well established corporation can work to provide just a fair and reasonable rate of return and then the remainder of the resources and efforts may be mobilized to fulfil their life style at the cost of stockholders. Their main concern is present benefit and long run survival. They do not take risky ventures which may provide higher rate of return to stockholders. They emphasize only those projects that generate moderate level of profit. One reason of not taking risky venture is that managers do not receive a fair share of compensation out of the value they generate for the risk they take.
Another reason to avoid high risk is that the impact of negative results to management is more serious than stockholders. The risk of managers can't be diversified as the risk of stockholders. Their managerial skill is limited to one company. If things go wrong, they are responsible and can lose their jobs. On the other hand, the risk of stockholders can be well diversified by investing their fund making a portfolio of different stocks of different business firms. If a business firm goes into loss, the impact of this loss is not so serious to stockholders. it can be compensated from the profit of another business firm in which they have invested their funds. Thus, there is conflict in the interest of stockholders and managers. Such type of agency problems can be solved in the following ways:
- Provision of cash kind incentives to managers,
- Provision of stock option and stock bonus,
- Limiting managerial autonomy,
- Setting up a monitoring unit,
- Reorganization of the managerial structure in such a way that the actions of managers are automatically verified,
- Threat of takeover,
- Threat of firing,
- Competition, and
- Fear of career damage.
No comments:
Post a Comment