Agency theory examines the relationship between the agents and principals in the business. In an agency relationship, two parties exist – the. Agency theory is part of the bigger topic of corporate governance. Agency refers to the relationship between a principal and their agent. Agency theory is used to understand the relationships between agents and principals. The agent represents the principal in a particular.
Majority of shareholders expect high dividends payouts when the company is making huge profits.
With this, not only they enjoy extra cash on their hands, it also boosts the current value of the capital stock they hold. The executives on the other hand, as a part of the long-term strategy, may decide to retain a large part of profits. Retention could be for a requirement of some technology advancement or some critical asset purchase in near-future.
In such situations, a conflict of interest may arise between the shareholders and executives. Such disagreements can create a feeling of contention between the owners and controllers of the company, often resulting in inefficiencies and sometimes even losses. Importance of Agency Theory There are two situations which make efforts on resolving agency conflicts all the more important.
Different Risk Appetite One of the major reasons for such strife is the levels of risk appetite each is willing to undertake. Shareholders are mostly not involved in the day-to-day working of the company and hence are not fully equipped to understand the rationale behind critical business decisions. They believe in the going concern concept of accounting and most of their decisions are taken keeping the long-term view of the company in mind.
While the shareholders are keen to increase the current and future value of their holdings, the executives are more interested in the long-term growth of the company. Thus, the differences in their approach create a feeling of distrust and disharmony. Super Self Centered Executives The situation could be exactly opposite also when the managers have interest in showing short-term performance to the owners to get their pay hikes.
This is more prevalent and a more dangerous situation. In a nutshell, there is a problem of goal congruence between the two parties. The corporate governance policies, which aim at aligning the objectives of both the principal and agents, are likely to resolve most agency conflicts.
As we know that there are no free lunches in this world, there are some agency costs also. Conclusion Agency theory in corporate finance is gaining momentum for all the right reasons. With markets getting volatile as ever, it becomes imperative that both, the interests of the shareholders and the company are taken care of.
The shareholders should trust the management of the company and go an extra mile to understand their day-to-day business decisions. Similarly, the management should also keep the interests of the true owners of the company in their mind. Courty and Marshke provide evidence on incentive contracts offered to agencies, which receive bonuses on reaching a quota of graduated trainees within a year. Options framework[ edit ] In certain cases agency problems may be analysed by applying the techniques developed for financial optionsas applied via a real options framework.
At the same time, since equity may be seen as a call option on the value of the firm, an increase in the variance in the firm value, other things remaining equal, will lead to an increase in the value of equity, and stockholders may therefore take risky projects with negative net present values, which while making them better off, may make the bondholders worse off.
See Option pricing approaches under Business valuation for further discussion. Nagel and Purnanandam notice that since bank assets are risky debt claims, bank equity resembles a subordinated debt and therefore the stock's payoff is truncated by the difference between the face values of the corporation debt and of the bank deposits.
Agency Theory in Corporate Governance | Meaning, Example, Importance
Jensen and William Meckling, an increase in variance would not lead to an increase in the value of equity if the bank's debtor is solvent. One method of setting an absolute objective performance standard—rarely used because it is costly and only appropriate for simple repetitive tasks—is time-and-motion studieswhich study in detail how fast it is possible to do a certain task.
These have been used constructively in the past, particularly in manufacturing. More generally, however, even within the field of objective performance evaluation, some form of relative performance evaluation must be used. Typically this takes the form of comparing the performance of a worker to that of his peers in the firm or industry, perhaps taking account of different exogenous circumstances affecting that.
The reason that employees are often paid according to hours of work rather than by direct measurement of results is that it is often more efficient to use indirect systems of controlling the quantity and quality of effort, due to a variety of informational and other issues e.
This means that methods such as deferred compensation and structures such as tournaments are often more suitable to create the incentives for employees to contribute what they can to output over longer periods years rather than hours. These represent "pay-for-performance" systems in a looser, more extended sense, as workers who consistently work harder and better are more likely to be promoted and usually paid morecompared to the narrow definition of "pay-for-performance", such as piece rates.
Principal–agent problem - Wikipedia
This discussion has been conducted almost entirely for self-interested rational individuals. In practice, however, the incentive mechanisms which successful firms use take account of the socio-cultural context they are embedded in FukuyamaGranovetterin order not to destroy the social capital they might more constructively mobilise towards building an organic, social organization, with the attendant benefits from such things as "worker loyalty and pride Whilst often the only feasible method, the attendant problems with subjective performance evaluation have resulted in a variety of incentive structures and supervisory schemes.What Is the Principal-Agent Problem?
One problem, for example, is that supervisors may under-report performance in order to save on wages, if they are in some way residual claimants, or perhaps rewarded on the basis of cost savings. Another problem relates to what is known as the "compression of ratings".
Two related influences—centrality bias, and leniency bias—have been documented Landy and FarrMurphy and Cleveland The former results from supervisors being reluctant to distinguish critically between workers perhaps for fear of destroying team spiritwhile the latter derives from supervisors being averse to offering poor ratings to subordinates, especially where these ratings are used to determine pay, not least because bad evaluations may be demotivating rather than motivating.
However, these biases introduce noise into the relationship between pay and effort, reducing the incentive effect of performance-related pay. Milkovich and Wigdor suggest that this is the reason for the common separation of evaluations and pay, with evaluations primarily used to allocate training.
Finally, while the problem of compression of ratings originates on the supervisor-side, related effects occur when workers actively attempt to influence the appraisals supervisors give, either by influencing the performance information going to the supervisor: Tournaments[ edit ] Much of the discussion here has been in terms of individual pay-for-performance contracts; but many large firms use internal labour markets Doeringer and PioreRosen as a solution to some of the problems outlined.
Here, there is "pay-for-performance" in a looser sense over a longer time period. There is little variation in pay within grades, and pay increases come with changes in job or job title Gibbs and Hendricks See the superstar article for more information on the tournament theory.
Workers are motivated to supply effort by the wage increase they would earn if they win a promotion. Some of the extended tournament models predict that relatively weaker agents, be they competing in a sports tournaments Becker and Huselidin NASCAR racing or in the broiler chicken industry Knoeber and Thurmanwould take risky actions instead of increasing their effort supply as a cheap way to improve the prospects of winning.
These actions are inefficient as they increase risk taking without increasing the average effort supplied. A major problem with tournaments is that individuals are rewarded based on how well they do relative to others. Co-workers might become reluctant to help out others and might even sabotage others' effort instead of increasing their own effort LazearRob and Zemsky This is supported empirically by Drago and Garvey Why then are tournaments so popular?
Firstly, because—especially given compression rating problems—it is difficult to determine absolutely differences in worker performance. Tournaments merely require rank order evaluation. Secondly, it reduces the danger of rent-seekingbecause bonuses paid to favourite workers are tied to increased responsibilities in new jobs, and supervisors will suffer if they do not promote the most qualified person. Thirdly, where prize structures are relatively fixed, it reduces the possibility of the firm reneging on paying wages.
As Carmichael notes, a prize structure represents a degree of commitment, both to absolute and to relative wage levels.
Lastly when the measurement of workers' productivity is difficult, e. Tournaments also promote risk seeking behavior. In essence, the compensation scheme becomes more like a call option on performance which increases in value with increased volatility cf. If you are one of ten players competing for the asymmetrically large top prize, you may benefit from reducing the expected value of your overall performance to the firm in order to increase your chance that you have an outstanding performance and win the prize.
In moderation this can offset the greater risk aversion of agents vs principals because their social capital is concentrated in their employer while in the case of public companies the principal typically owns his stake as part of a diversified portfolio.