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Agency Theory Project

Agency theory explains the relationship between principals (like shareholders) and agents (like company executives) in which the principal delegates work to the agent. There is an inherent conflict of interest since the goals of the principal and agent may differ. The theory aims to align their goals and reconcile differences in risk tolerance. It recognizes that agents may pursue self-interested objectives that deviate from the principal's goals. For example, managers may act in their own interest rather than shareholders' interests due to problems like asymmetric information and uncertainty.

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Hassan Ali Burki
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213 views

Agency Theory Project

Agency theory explains the relationship between principals (like shareholders) and agents (like company executives) in which the principal delegates work to the agent. There is an inherent conflict of interest since the goals of the principal and agent may differ. The theory aims to align their goals and reconcile differences in risk tolerance. It recognizes that agents may pursue self-interested objectives that deviate from the principal's goals. For example, managers may act in their own interest rather than shareholders' interests due to problems like asymmetric information and uncertainty.

Uploaded by

Hassan Ali Burki
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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AGENCY THEORY

Definition
A theory explaining the relationship between principals, such as a shareholders, and agents, such as
a company's executives. In this relationship the principal delegates or hires an agent to perform work.
The theory attempts to deal with two specific problems: first, that the goals of the principal and agent
are not in conflict (agency problem), and second, that the principal and agent reconcile different
tolerances for risk.

Explanation
Agency Theory explains how to best organize relationships in which one party determines the work
while another party does the work. In this relationship, the principal hires an agent to do the work, or to
perform a task the principal is unable or unwilling to do. For example, in corporations, the principals are
the shareholders of a company, delegating to the agent i.e. the management of the company, to
perform tasks on their behalf. Agency theory assumes both the principal and the agent are motivated
by self-interest. This assumption of self-interest dooms agency theory to inevitable inherent conflicts.
Thus, if both parties are motivated by self-interest, agents are likely to pursue self-interested objectives
that deviate and even conflict with the goals of the principal. Yet, agents are supposed to act in the sole
interest of their principals.

Agency theory is the branch of financial economics that looks at conflicts of interest between people
with different interests in the same assets.

This most importantly means the conflicts between:

 Shareholders and managers of companies


 Shareholders and bond holders.

The theory explains the relationship between principals, such as a shareholders, and agents, such as a
company's managers. In this relationship the principal delegates (or hires) an agent to perform work.

The theory attempts to deal with two specific problems:

 How to align the goals of the principal so that they are not in conflict (agency problem), and
 That the principal and agent reconcile different tolerances for risk.
CONFLICTS BETWEEN MANAGERS AND SHAREHOLDERS
Why conflict of interest between shareholders and management?

To address the conflict of interest between shareholders and management, it is important to stress that
even within the same class of shareholders, there may be conflicts, this conflict may relate to what
proportion of the company’s profit should be paid in the form of dividend and what proportion should
be retained for future investments and for capital investment purposes.

Other potential conflicts may involve company’s ethical policies, its corporate and social responsibilities
policies.

The agency theory, considering the potential conflicts of interest between shareholders and
management may arise as a result of several factors, some of such factors include:

 Reward to management
 Risk attitudes of management and shareholders
 Takeover decisions by management
 Time horizon of management

SELF-INTERESTED BEHAVIOR
Agency theory suggests that, in imperfect labor and capital markets, managers will seek to maximize
their own utility at the expense of corporate shareholders.

Agents have the ability to operate in their own self-interest rather than in the best interests of the firm
because of asymmetric information (e.g., managers know better than shareholders whether they are
capable 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, positive 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 profitable opportunities in which the firm's shareholders would prefer they invest. Outside
investors recognize that the firm will make decisions contrary to their best interests. Accordingly,
investors will discount the prices they are willing to pay for the firm's securities.

The interest of shareholders may include:

 Increasing earnings per share (EPS), and current share prices


 Increasing investor ratios such as dividend per share (DPS), dividend cover, dividend yield, price-
earning (P/E) ratio
Others may include the company improving its corporate and social responsibilities
Management interest may include:

 Managing the firm to achieve its objectives


 Increasing the wealth and size of the company, by expanding the company’s activities, the bigger
the size of the company they manage the better they are perceived to be
 Increasing their personal wealth by paying themselves high remunerations and other bene fits

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