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Agency theory

(the problem of agency and solution)

Agency theory has been used to explain the situations where an individual (agent) delegates
responsibility for a task to other persons (principles) (Fama, 1980). Agency theory is about
either the relationship between companys shareholders and their managers, or the existence
of the problem between both.
In centuries back, an entrepreneur of a company had two roles, manager and residual risk
bearer. For the company, it had the imperial structure, employees have no choice to follow the
entrepreneurs' decisions, otherwise they may be fired.
However, along with the development of productive forces and the amplification of enterprise
scale, the principal-agent relation comes into being. More specifically, because the
productivity development was driving the division of labor and specialization, some people
may have relative advantage on knowledge and skills compared to the other; and as the
enterprise becomes larger and more complex, the owner seek to professional manager to
running their business instead of themselves. Hence the owner(principal) hires the manager
(agent) to perform the company on their behalf. Thereby, the agency relationship has been
raisin when proprietary right and management right separation.
Moreover, the relationship of principal-agent is due to the difference preference and interest
between principals and agents. For instance, the owner pursue maximum profits while the
agent ppursue self-benefit, this inevitably leads to interest conflict. The agency problems
arise the relationship between principal and agent, that the principal employs the agent to
perform certain actions on his behalf and maximize principals wealth. (Jensen & Meckling,
1976). It exists in practically every organization whether a business, government, university,
church and so on. Since the relationship between the stockholders and the managers of a
corporation fits the definition of a pure agency relationship, it should come as no surprise to
discover that the issues associated with the separation of ownership and control in the
modern diffuse ownership corporation are intimately associated with the general problem of
agency. Jehnsen and Meckling (1976) suggest that there are two major solutions to
shareholder-manager conflict : close monitoring of management behavior and creating
motivation for managers to act in firms best interests.
In reality, owners pursue organizational goals while agents pursue personal goals. How to
align these different interests and goals is the key factor for agency problems. The literature
materials introduced a lot of institutional measures to solve the problem, such as: complete
contracts, incentive pay, takeover, insurance, higher leverage, ownership concentration, tough

screening processes, incentives for good behavior and punishment for bad behavior,
watchdog bodies, and so on. To a short summary, there are three major factors that contribute
to agency problems within modern enterprise.

Divergence of ownership and control, the owner (principal) appoint managers

(agents) to perform the company on their behalf.

The goals of the managers (agents) differ from the shareholders / ownership
(principals). Managers are likely to maximizing their own wealth rather than the
wealth of shareholders.

Information asymmetry. Managers running the company on day-to-day basis while

shareholders only receive season or annual reports.

In this essay, we aim to explore the main agency problems in firms and then using example to
analyze how these mechanisms work for dealing with agency problem as well as the
advantages and disadvantages of these mechanisms will be stated.

What is the difference of maximum benefit between shareholders and managers?

First of all, the shareholders wealth is increased through the cash they receive in dividend
payments and the capital gains arising from increasing share prices. It follows that
shareholder wealth can be maximised by maximising the purchasing power that shareholders
derive through dividend payments and capital gains over time. From this view of shareholder
wealth maximisation, we can identify three variable that directly affect shareholders wealth:
1)the magnitude of cash flows accumulating to the company; 2)the timing of cash flows
accumulating to the company; 3)the risk associated with the cash flows accumulating to the
company. (Berger, Phillip G. , EliOfek. Diversificationps Effect on Firm Value [J]. Journal of
Financial Economics,1995, 37: 39 - 65.)

How is shareholder wealth maximised?

The indicator usually taken is a companys ordinary share price, since this will reflect
expectations about future dividend payments as well as investor views about the long-term
prospects of company and its expected cash flow. On the other hand, all current market price
of the companys ordinary shares is the shareholder wealth.
There are four stages to illustrate the processing to make the shareholder wealth maximum.
At the beginning, manager should analysis the positive net present value of the projects or
potential project to find out the variables that influence the shareholder wealth. Secondly,
when NPV is calculated, the sum of the NPVs of the project should be same as the companys
whole NPV, and in here the NPVs of the project also be called corporate present value. For
the third stage, the NPV of the company as a whole is accurately reflected by the market
value of the company through its share price. (Denzil W. and Antony H. Corporate Finance
principles & practice. Prentice Hall, 2007, p11) On the same time, the efficiency of the stock
is the most important element of the linking between the second stage and the third stage, the
frequency and the scale of the share price change can show the new condition of the
company, in the ending, it is obviously that the share price reflect the wealth of the
shareholder and the company is maximised will lead to the shareholder wealth be maximised.
Example of good financial decisions, in the sense of decisions that promote maximisation of
a companys share price, include the following:1)using NPV to assess all potential projects
and then accepting all projects with a positive NPV; 2)raising finance using the appropriate
mixture of debt and equity in order to minimise a companys cost of capital; 3)adopting the
most appropriate dividend policy, which reflects the amount of dividends a company can
afford to pay, given its level of profit and the amount of retained earnings it requires for
reinvestment; 4)managing a companys working capital efficiently by striking a balance
between the need to maintain liquidity and the opportunity cost of holding liquid assets.
(Denzil W. and Antony H. Corporate Finance principles & practice. Prentice Hall, 2007, p11)

According to agency theory by Jensen and MecHing, they put forward the conflict between
shareholders and managers. In the firm, because the manager cannot hold the total surplus
value, the benefits that are gained by manager must share with shareholders and managers.
Therefore, they might find a reason of negative work. Even they might transform the

company resources into personal gains. For example, they might build a luxurious office for
themselves, or they might go to travel in where is without a project of this company. Both of
shareholders and managers want to be wealth maximised, but this condition is difficult to
achieve as the same time, the conflict appears.
For example, there are two potential projects, one project with high risk has high profit, the
other is low risk but it can be low return. The shareholders might be a risk preference so that
they could choose the project wich has high profit with high risk. However, managers may
prefer the project with low risk and low return. The reason could the project with low risk has
a high possibility to success and it can insure managers status or reputation. Therefore the
contradiction between the manager and shareholder appears all the time. The agency theory is
used to deal with these problems.
A failure of company governance
An example of problems encountered with agency theory can be found in the episode of the
Enron Scandal of American. Enron was established in 1985 and used to be one of the largest
energy companies in the United States, at one time in the top seven Fortune 500 companies.
Since this is a complicated case, we will just consider the reward system for executives to
analyse the problems with agency theory encountered at Enron.
Enron's compensation and performance management system was designed to retain and
reward its most valuable employees, however, the setup of the system contributed to a
dysfunctional corporate culture that became obsessed with focusing only on short-term
earnings to maximize bonuses. A historical account of Enrons demise records:
Employees constantly looked to start high-volume deals, often disregarding the quality of
cash flow or profits, in order to get a higher rating for their performance review. In addition,
accounting results were recorded as soon as possible to keep up with the company's stock
price. This practice helped ensure deal-makers and executives received large cash bonuses
and stock options. Enron's auditor firm, Arthur Andersen involved this case as well and was
accused was accused of applying reckless standards in their audits because of a conflict
interest over the significant consulting fees generated by Enron. In 2000, Arthur Andersen
earned $25 million in audit fees and $27 million in consulting fees (this amount accounted
for roughly 27% of the audit fees of public clients for Arthur Andersen's Houston office).
First of all in this case, the companys management only focussed on boosting their own
benefits rather than maximising shareholder profit. Secondly, asymmetry of information
existed between corporate management and shareholder. In Enron, the companys financial
report purposely displayed misleading information for shareholder and public to interpret,
consequently, shareholders could not really full appreachiate the financial condition and the
operating achievement of company.
Solutions of agency problem between shareholder and management

Solutions of agency problem between shareholder and management depend on different type
of company and diverse case. In general, there are four ways to deal with this conflict, they
are monitoring managers behaviour, incentive pay, takeover and managerial ownership
Monitoring managers behaviour
Jensen and Meckling suggested that there are two ways of seeking to optimise managerial
behaviour in order to encourage shareholder and manager goals are mutually congruent.
Shareholder can either closely monitor the actions of management, or, managerial contracts
can contain clauses designed to promote common goals. (Denzil Watson & Antony Head,
fifth edition, 2010)
To monitor managerial actions, shareholders can choose which firm audits a companys
accounts and produces the corporate financial report, which can be external and independant
of management. Moreover shareholders can ask managers to produce not only an annual
report but also more frequent short term periodic financial reports such as montly, quarterly
or half yearly reports. Alternatively shareholders can request managers insure the financial
report of their company, and the auditor can be chosen by the insurance company.
Considering the Enron as an example, if Enron had been forced to purchase insurance for the
companys financial reporting, and the firm audited by the insurance companies choice of
auditor, it would have been much hard for Enrons financial report to contain misleading data.
An alternative means of converging shareholder and management goals is through careful
clause writing in managerial contracts. Such clauses can contain formalised constraints,
incentives and punishments to encorage management in favour of shareholder goals, and, are
called optimal contracts. There are problems, however, such contracts will involve agency
costs including opportunity cost, the cost of auditor, the cost of managers incentive pay and
bonus, loss of wealth owing to suboptimal behaviour by agent. (Denzil Watson & Antony
Head, fifth edition, 2010)
Consider first opportunity costs. Shareholders and managers may hold different opinions for
choosing diverse projects to invest in. If a company follows with managerial ideas of
investing a project, another investment which is supported by shareholders will be missed
when this project might have earned greater profits for the company than that chosen by
Secondly the cost of an auditor. Clearly a company will need to pay audit fees and consulting
fees to their auditor firm. As we can see from the Enrons example, Enron paid $25 million in
audit fees and $27 million in consulting fees to Arthur Andersen in 2000. Furthermore, if
companies buy insurance for their financial report, the insurance fees will also be an agency
Thirdly, the is the possibility of loss in wealth due to poor managerial behaviour or
motivation. Some contractual constraints such as restricting managerial expenditure or
forcing overburdening reporting of ever decision could lead to this through management

considering they are not trusted by shareholders. For these reasons, managers may focus
more on how to satisfy their individual benefits rather than shareholders profit.
It is clearly important for these components of agency costs to be carefully considered by
shareholders, and, consequently managerial contracts crafted to reflect the needs of individual
companies. Moreover, the effort of closely monitoring a company may be both difficult and
costly for certain companies. Managerial contracts for such companies may therefore
alternatively include a bonus structure created to improve company performance thus
achieving an alignment between shareholders and managerial goals, and such incentives may
be pragmaticly more practical for a company.(Denzil Watson & Antony Head, fifth edition,
Incentive pay and bonus: CEO compensation
In principle shareholders may believe that managers can be suitably motivated with
renumiration which includes high salaries, bonuses, options and pension. It is especially the
long-term bonuses and options that can constitute the most important part of companies
Long-Term Incentive Plans (LTIP).
Share options can encourage managers to concentrate on maximize shareholders wealth.
Managers are allowed to buy agreed amounts of a companys shares at a fixed price, which
will be guarantee through contract. (Denzil Watson & Antony Head, fifth edition, 2010) For
example, a manager could be allowed to purchase company shares at a guaranteed price of 1
per share in three years time so long as they achieve a specific goal, even if the stock market
price at the time of purchase is considerably higher. In this way managers not only accrue
more benefits but can also become a shareholder. Consequently, shareholder profit
maximisation can be achieved in two ways: managers are incentivised to maximise future
share value and will also have common goals in becoming shareholders themselves.
In contemporary companies, it is apparent that increasingly firms commit to motivate their
managers in this way. The following bar chart indicates the change which is average
remuneration for CEOs in S&P 500 firms from 1992 to 2002. As we can see, in the past
salary used to comprise the largest part of company CEOs in 1992 accounting for 38percent
of earnings. At the same share options rewarding CEOs was just 24percent of overall income.
By 2001 there had been a significant change, by this time 54percent of CEO salaries were
derived from share options. It is apparent that a greater number of shareholders consider that
share options provide a more efficient way of motivating managers to achieve the goal of
maximising profit for the shareholder. (Denzil Watson & Antony Head, fifth edition, 2010)

Definition: In business, a takeover is the purchase of one company (the target) by another
(the acquirer, or bidder). In the UK, the term refers to the acquisition of a public company
whose shares are listed on a stock exchange, in contrast to the acquisition of a private
company. r8
Merger: combining of two businesses under common ownership (most are friendly, some
Acquisition: A company is sold to another company.

Takeover occurrence



The UK and the US

Occur readily

Dispersed ownership

France and Italy

Happen with difficulties

The strong




Do not happen often

The dual board structure


Do not happen often

Companies have interlocking

sets of ownerships known as


Do not happen often

The state majority-owns most

publicly listed companies

Sub-Saharan Africa


The shallowness
capital markets



According to a research, the above table is summarised to describe how often the takeover
happen in different countries, and why this situations are so different. This table describe how
often the takeover happen in different countries, and why this situations are so different.
Corporate takeovers occur readily in the United States and in the United Kingdom. They
happen with difficulties in France and Italy because of the strong ties among companies and
the Establishment. They do not happen often in Germany because of the dual board structure,
nor in Japan because companies have interlocking sets of ownerships known as keiretsu, nor
in the People's Republic of China because the state majority-owns most publicly listed
companies there. In Sub-Saharan Africa, corporate takeovers - particularly hostile takeovers are infrequent because of the shallowness of the capital markets.
Takeover is an important corporate governance mechanism, especially in countries with
dispersed ownership such as the UK and the US. Manne pointed that Only the takeover
scheme provides some assurance of competitive efficiency among corporate managers and
thereby affords strong protection to the interest of vast numbers of small, non-controlling
shareholders. (H. Manne. 1965)
For the takeover, the main motivation is considered to be the managers mismanagement.
If incentive contracts with management team is binding and working well, managers will try
to achieving maximizing shareholders wealth. So, if there no accidents, normally, company
performance will not lead to takeover. In contrast, if incentive contracts with management
team is binding and working badly, managers more possible to using mismanagement to
protect their personal benefits. In this situation, takeover can be seen as a way of
renegotiating the contract.
From 1997 to 2000, there are several cases of takeover occurred in the worlds, such as,
British Petroleum acquires Amoco ($48bn)
Exxon acquires Mobil ($80bn)
Daimler-Benz acquires Chrysler ($38bn)

Travellers Group acquires Citicorp ($83bn)

Deutsche Bank acquires Bankers Trust ($10bn)
An argument of solution for agency problem
Managerial Ownership Concentration, Huson Joher and Ali Ahmed (2009) mentioned that
managerial ownership concentration of the firm could serve as monitoring substitute to
reduce agency conflict. When the risk at lower level, it is significant and positive relations
with managerial ownership concentration. However, when the risk at higher level, appear to
have significant and negative relationship with managerial ownership. The low level-risk
means manager will not or take little risk project for management , this happened when they
have low managerial ownership. In contrast, the high risk means manager may take more risk
projects for management when they have some managerial ownership or their benefits in
large extent connected with the share price.
Normally, the managerial ownership is a internal control mechanism and it may be very
useful to reduce agency conflict in some extent. As we mentioned before, the option
mechanism which is a powerful methods, used frequently by shareholders for the agency
problem. But, diferent level of managerial ownership will also lead to different problems
such as:
low managerial ownership problem and middle managerial ownership problem.
These two problems can be influenced by the managers personal characters, like whether
they are risk preference or risk averse. For below situation, this personal character will not be
Low Managerial Ownership situation
When the managers do not have or just have a little share of a company. They may more
focus on how to avoid lose their job.
Evidence of this self-interested managerial behaviour includes the consumption of some
corporate resources in the form of perquisites and the avoidance of optimal risk positions,
managers may bypass profitable opportunities in which the firm's shareholders would prefer
they invest. Managers fundamental objective may become maximizing the size of the firm.
By creating a large, rapidly growing firm, executives increase their own status, create more
opportunities for lower- and middle-level managers and salaries, and enhance their job
security because an unfriendly takeover is less likely.6

Middle managerial ownership situation

When the managers ownership of company rising to some extent or the option incentive pay
takes a big percentage, managers benefits will be connected more closely to the shares price.
In this situation, managers fundamental objective may become maximizing share price.

Nature outcome will push company to take more adventures, because managers will choose
high risky projects to rising share price. Even the project finally failure, they will only bear a
fraction of the cost, however, shareholders will become the biggest risk taker or victims.
They documented a positive causal relationship between managerial ownership and risk
taking. As the proportion of managerial ownership increases, there is a tendency among
management to undertake more risky investment. Even though there are potential losses from
such investment undertaking, it may not result greater losses to managers, as they will bear
only the fraction of the losses. This is further supported by Saunders, Strock, and Travlos
(1990) who suggested that the higher managerial ownership might even worsen the agency
problems between owners and managers because of higher risk undertaking. (Journal of
Management Research, Huson Joher Ali Ahmed2009)

Corporate governance problems have received a lot of attention owing to a number of highprofile corporate collapses and the publicizing of self-serving executives remuneration
package. Mechanisms, such as complete contracts, incentive pay, takeovers, higher leverage,
ownership concentration ,in some content, can help shareholders protect their benefits.
However, no firm and organization can solve this problem completely. The reason could be
the human natures and the costs outweigh the worth of the results. Among these methods, the
UK Corporate Governance system has traditionally stressed internal controls, financial
reporting and accountability, rather than external legislation.
1. Denzil Watson and Antony Head, corporate finance. 5th edition. Published The financial
times 2007.
2. Managerial Ownership Concentration and Agency Conflict using Logistic Regression
Approach: Evidence from Bursa MalaysiaHuson Joher and Ali Ahmed (2009) Journal of
Management Research ISSN 1941-899X, 2009, Vol. 1, No. 1: E9
3. Saunders, A., F. Stock, & N.Travlos, (1990). Ownership Structure, deregulation, and bank
risk-taking journal of financial research vol.5 pp: 249-259.
4.H. Manne. 1965. Mergers and the Market for Corporate Control, Journal of Political
Economy 73: 110-120.
5. Demsets, H. & K. Lehn, (1985). The Structure of Corporate Ownership, Causes and
Consequences Journal of Political Economy, vol 93.
6. Stein , Jeremy. Agency, Information and Corporate Investment [R]. NBER, Working Paper,
7. Claessens, S. , S. Djankov, L. H. P. Lang. The Separation of Ownership and Control in
EastAsian Corporations[ J ]. Journal of Financial Economics, 2000, 58: 81- 112.
8. (http://en.wikipedia.org/wiki/Enron_scandal) [Accessed 14th February]
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Journal of Finance,1997,52(2):111-133.
10. Berger, Phillip G. , EliOfek. Diversificationps Effect on Firm Value [J]. Journal of
Financial Economics,1995, 37: 39 - 65.