Rise of Agency Problem In large corporations, shareholders are owners of the company. Managers are employed and are expected to act on behalf of them to maximise shareholders’ wealth. However, it is human nature for managers to put their self-interests ahead of the shareholders’ and do what is in their own personal best interest.
Figure 1.1 Fisher Separation Theorem (Fonseca, n.d.)
According to Fisher Separation Theorem (Fisher 1930), managers’ decision to invest is independent of shareholders’ consumption preferences. From Figure 1, C* and F* are market opportunities while Y* is the optimal investment point. Depending on individuals, there are multiple optimal consumption points but there is only one optimal investment point. Regardless of investors’ preferences, firm should only undertake investments when financial market line is tangent to the production possibility frontier curve (Copeland et al. 2005). Thus, when shareholders employ managers to perform investments, this leads to separation of ownership and control. Agency problem arises when the agents, who are managers in case, do not adhere to their responsibilities and put their personal interest before the principals, who are shareholders in case.
Separation of Ownership from Control
While shareholders own the company, managers are responsible in running the firm and making investment decisions. Managers are supposed to act in the interest of shareholders, that is, to maximise shareholders’ wealth, but are more incentivised to maximise his/her own wealth. For example, managers grow the firm to prevent a takeover to secure his/her position in the company. However, a takeover may lead the firm to greater heights and benefit shareholders.
Managers and shareholders may receive different information about the same project or financial asset. For example, managers may have company’s management and financial accounts and know about the inside-outs of the firm, while shareholders only have annual financial reports, and these may even be manipulated. Asymmetric information may also occur because it is difficult or expensive for shareholders to retrieve information about and verify what managers are doing.
Different Risk Tolerance
As shareholders’ liabilities are limited to the amount they invested in the company, shareholders are less risk-averse than managers. Managers, however, prefer to take on less risk as it may jeopardise their job security or compensation. For example, when a manager takes on a project, he/she has the responsibility to deliver success, which will eventually increase shareholders’ wealth. Should the project fail, shareholders risk losing their investments and only their investments, while managers risk losing their jobs or a decrease in compensation.
Consequences and Implications
Ross, Westerfield, and Jaffe (2005) describe the consequences of agency problems as agency costs – costs incurred due to the separation of ownership and control. According to Jensen and Meckling (1976), agency costs include the monitoring expenditures of the principal, the bonding expenditures by the agent, and the residual loss.
Monitoring expenditure includes costs shareholders bear to look over the actions of managers, such as auditing costs. Although auditors are employed to ascertain the validity and credibility of financial statements, auditors themselves are agents too, thus there is a risk of asymmetric goals between the auditors and the shareholders (Institute of Chartered Accountants in England & Wales 2005). Bonding expenditures includes measures taken to align managers’ interests to shareholders’ so they act in consistent with their goals, that is, to increase shareholders’ wealth. One example is providing managers with a portion of ownership of the firm. Since managers are also owners, they would behave in sync with the principals of the firm and thus maximise their own wealth. Residual