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Tuesday, January 22, 2019

Agency Costs and Financial Decision-Making

effect cost and Financial Decision-Making The Concept An force birth is a contr work under which one or to a greater extent persons (the principal(s)) engage a nonher person (the agent) to perform virtually service on their behalf which involves delegating some conclusion making authority to the agent. If both parties to the relationship argon utility increasers and they whitethorn wealthy person divergent goals and objectives, and there is providedid reason to believe that the agent bequeath not always act in the best interests of the principal (Jensen, Michael C. , and William H.Meckling. Theory of the Firm, Managerial Behavior, Agency Costs, and holdership Structure. Journal of Financial Economics 3 (October 1976), 305-360) The concept of operation embody recognizes there ar fundamental differences in how sh beholders, managers, and til now bondholders interpret their single relationships to an validation. While they may sh atomic number 18 some jet goals an d objectives, there is the effectiveness for at least some objectives to emerge that are focused ofttimes on individual enrichment than on the well-being of the whole.For example, managers may be to a greater extent focused on building a reputation for themselves, possibly creating their testify power bases within the structure of the larger organizations. Shareholders may become much(prenominal) focused on earning dividends now and less(prenominal) on the future of the business. Bondholders may be concerned only with the project associated with the bond issue, and lose rush of how the overall st king of the company piece of tail have a shun impact on the return earned from that bond. ( http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. tmlixzz14WVaUW4g) Agency Costs is an economic concept which is defined as the cost incurred by an entity in relation to issues like varied goals and objectives of the management and shareholders and information asymmetry . Self-Interested Behavior Agency theory suggests that, in imperfect labor and capital markets, managers result search to maximize their own utility at the expense of incorporated shareholders. Agents have the ability to operate in their own self-interest or else than in the best interests of the unbendable because of asymmetric information (e. g. , managers know better than shareholders whether they are apable of meeting the shareholders objectives) and uncertainty (e. g. , myriad factors contribute to final outcomes, and it may not be evident whether the agent directly caused a given outcome, collateral or negative). Evidence of self-interested managerial behavior includes the consumption of some corporate resources in the form of perquisites and the avoidance of optimal risk positions, whereby risk-averse managers bypass useful opportunities in which the firms shareholders would prefer they invest. Outside investors recognize that the firm will stupefy decisions contrary to their best interests.Accordingly, investors will discount the determines they are willing to support for the firms securities. (Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and Incentives. Berlin Springer-Verlag, 1987). A potence business office conflict arises whenever the manager of a firm owns less than 100 percent of the firms viridity stock. If a firm is a sole proprietorship managed by the owner, the owner-manager will undertake actions to maximize his or her own welfare. The owner-manager will probably measure utility by personal wealth, but may trade off other considerations, much(prenominal) as leisure and perquisites, against personal wealth.If the owner-manager forgoes a portion of his or her monomania by selling some of the firms stock to impertinent investors, a potential conflict of interest, called an agency conflict, arises. For example, the owner-manager may prefer a more well-situated lifestyle and not work as vigorously to maxi mize shareholder wealth, because less of the wealth will now accrue to the owner-manager. In addition, the owner-manager may decide to consume more perquisites, because some of the cost of the consumption of benefits will now be borne by the outside shareholders. Bamberg, Giinter, and Klaus Spremann, eds. Agency Theory, Information, and Incentives. Berlin Springer-Verlag, 1987. ) In the major(ip)ity of large in public traded corporations, agency conflicts are potentially quite portentous because the firms managers generally own only a small percentage of the common stock. Therefore, shareholder wealth maximization could be subordinated to an assortment of other managerial goals. For instance, managers may have a fundamental objective of 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 tak eover is less likely. As a result, incumbent management may pursue variegation at the expense of the shareholders who can easily diversify their individual portfolios plainly by buying shares in other companies. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) Managers can be encouraged to act in the stockholders best interests through inducings, constraints, and punishments.These methods, however, are effective only if shareholders can observe all of the actions taken by managers. A moral risk problem, whereby agents take unobserved actions in their own self-interests, originates because it is infeasible for shareholders to monitor all managerial actions. To reduce the moral hazard problem, stockholders must incur agency be. Measuring Agency Costs The report behind assessing agency cost is to attempt to identify what impact these differences in objectives and the flow of information between the agent or manager and the shareholders is h aving on the overall profitability of the organization.By correctly identifying and addressing issues of agency cost, it is possible to minimize the lure of those factors, at least enough to allow the organization to continue sorrowful forward, rather than running the risk of failure. Determining the agency cost unremarkably begins with looking closely at the potential costs or risks associated with including some type of agent or manager in the organizational structure. For example, one potential risk would be the possibility that the individual who is appointed as an officer in the company could seek to use company assets for his or her own personal gain, to the detriment of the company.At the same time, agency cost in like manner looks at the expense involved in anticipating potential abuses of power and resources, and structuring the organization so that abuse is less likely to occur. This may include crack incentives to key employees that promote loyalty and lessen the cha nce of misappropriation of resources, or structuring the accounting process so that a series of checks and balances create a separation of control, effectively preventing any one individual from having too much power within the organization. http//www. wisegeek. com/what-is-an-agency-cost. htm) Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. The notion of agency costs is peradventure most associated with a seminal 1976 Journal of Finance paper by Michael Jensen and William Meckling, who suggested that corporate debt levels and management equity levels are both influenced by a wish to contain agency costs. There are three major types of agency costs 1) Expenditures to monitor managerial activities, such(prenominal) as canvas costs (2) Expenditures to structure the organization in a way that will limit undesirable managerial behavior, such as appointing outside members to the batting order of directors or restructuring the companys business units and management hierarchy (3) Opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth.In the absence of efforts by shareholders to alter managerial behavior, there will typically be some loss of shareholder wealth due to inappropriate managerial actions. On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed with shareholder interests. Therefore, the optimal amount of agency costs to be borne by shareholders is determined in a cost-benefit contextagency costs should be increased as long as each additive dollar bill spent results in at least a dollar increase in shareholder wealth. (http//www. referenceforbusiness. om/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) Financi al decision making for dealing with agency costs There are 2 polar positions for dealing with shareholder-manager agency conflicts. At one extreme, the firms managers are equilibrise entirely on the basis of stock price changes. In this case, agency costs will be low because managers have great incentives to maximize shareholder wealth. It would be extremely difficult, however, to hire talented managers under these contractual terms because the firms earnings would be affected by economic events that are not under managerial control.At the other extreme, stockholders could monitor every managerial action, but this would be extremely costly and inefficient. The optimal solution lies between the extremes, where executive compensation is tied to operation, but some monitoring is in any case undertaken. In addition to monitoring, the following mechanisms encourage managers to act in shareholders interests (1) performance-based incentive plans (2) direct intervention by shareholders (3) the threat of firing (4) the threat of takeoverMost publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If corporate performance is above the performance targets, the firms managers earn more shares. If performance is below the target, however, they receive less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives.First, they commotion executives incentives to take actions that will enhance shareholder wealth. Second, these plans help companies attract and entertain managers who have the confidence to risk their financial future on their own abilitieswhich should lead to better performance. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) An increasing percentag e of common stock in corporate America is owned by institutional investors such as insurance companies, pension funds, and mutual funds.The institutional silver managers have the clout, if they choose, to exert considerable influence over a firms operations. institutional investors can influence a firms managers in two primary ways. First, they can meet with a firms management and offer suggestions regarding the firms operations. Second, institutional shareholders can athletic supporter a proposal to be voted on at the annual stockholders meeting, even if the proposal is opposed by management.Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion. (http//www. referenceforbusiness. com/encyclopedia/A-Ar/Agency-Theory. htmlixzz14WVaUW4g) In the past, the likelihood of a large companys management being ousted by its stockholders was so remote that it posed little th reat. This was true because the ownership of most firms was so widely distributed, and

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