Agency cost Totally Explained

Everything about Agency Cost totally explained

An agency cost is an economic concept on the cost incurred by an organization that's associated with problems such as divergent management-shareholder objectives and information asymmetry. The costs consist of two main sources: 1. The costs inherently associated with using an agent (for example the risk that agents will use organizational resource for their own benefit) and 2. The costs of techniques used to mitigate the problems associated with using an agent (e.g the costs of producing financial statements or the use of stock options to align executive interests to shareholder interests).
   The information asymmetry that exists between shareholders and the Chief Executive Officer is generally considered to be a classic example of a principal-agent problem. The agent (the manager) is working on behalf of the principal (the shareholders), who doesn't observe the actions of the agent. This information asymmetry causes the agency problems of moral hazard and adverse selection.
   Agency costs mainly arise due to divergence of control, separation of ownership and control and the different objectives (rather than shareholder maximization)the managers consider. Managers usually want to satisfy their own objectives such as job-guarantee, less work by investing in pt projects(projects that are not valuable positively for the company), by selecting projects with low payback period etc.
   According to Ross and Westerfield (Corporate Finance, 7th edition): when a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm. These strategies may be: 1. Incentive to take large risks; 2. Incentive toward underinvestment; 3. Milking the property.
   There are various actors in the field and various objectives that can incurr costly correctional behaviour. The various actors are mentioned and their objectives are given.

Management

Management, specifically the CEO, has their own objectives to pursue. The classical ones are empire-building, risk averse investments and manipulating financial figures to optimize bonusses and stockprice-related options. The latter may be just outright fraudulent, but the first two certainly aren't. They erode the stockholders value, but a risk averse strategy isn't by definition fraudulent.

Bondholders

Bondholders typically value a risk averse strategy since that will increase the chances of getting their investment back. Stockholders on the other hand are willing to take on very risky projects. If the risky projects succeed that'll get all of the profits themselves, whereas if the projects fail the risk is shared with the bondholder.
Bondholders know this of course, so that'll have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects should they arise, or that'll simply raise the interest rate which in turn increases the cost of capital for the company.

Board of directors

The board of directors in the literature is typically viewed as aligned with either management or with stockholders, but recent theory suggests that they too have own objectives. A very easy non-executive director is valuable to the CEO who gets more leeway, but a very critical non-executive director may be just as valuable to the stockholders. Directors further don't want to be the only ones who are critical towards the CEO, because that increases their chances of being removed from the board. The behaviour of directors isn't well known and the theory is largely scarce on this matter.

Labour

Labour is sometimes aligned with stockholders and sometimes with management. They too share the same risk averse strategy, since they can't diversify their labour whereas the stockholders can diversify their stake in the equity. Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On the other hand, if the CEO is clearly underperforming the company is in threat of a hostile takeover which typically leads to job-loss as well. They are therefore likely to give the CEO considerable leeway in taking risk averse projects, but if the manager is clearly underperforming, that'll likely signal that to the stockholders.

Other stakeholders

Other stakeholders such as government, suppliers and customers all have their specific interests to look after and that might incur additional costs. The literature however mainly focusses on the above categories of agency costs.

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