Agency Theory

Question 1

Agency theory

Answer 1

• Is the study of incentives to motivate
• Examines the relationship between an agent and a principal
• Explains how best to organise relationships in which one party (principal) determines the work, which another party (agent) performs

Question 2

Agency problem

Answer 2

• The shareholders (principals) hire managers (agents) to make decisions that are in the best interests of the shareholders. People are self-interested and will therefore have conflicts of interest in any cooperative endeavors
• Information asymmetry occurs where management (agents) have the advantage of access to information within the company that the owners(principals) don’t have. This results in the principal’s inability to control the desired action of the agent.
• An agent responds to incentives and will not always act in the best interests of the principal

Question 3

The contract

Answer 3

The agency contract spells out the terms of the agency relationship
The contract outlines the compensation to be made by the principal to the agent, given that a set of conditions are met

Question 4

Objectives

Answer 4

• Principles objective is to maximise the value of agent’s productivity - cost pay for agent
• Agent objective is to maximise their own

Question 5

Agency costs

Answer 5

• Monitoring cost: Board of directors monitor and restrict agents to maximize benefit of shareholders
• Bonding cost: Mechanism that Agent behave in the interest of principle of they will have to compensate if they fail to do so.

Question 6

Agency loss

Answer 6

Residual Loss: Agent’s decisions do not serve principle’s interest due to divergent in interests despite the use of Monitoring and Bonding cost. It is more severe when the divergence is substantially and information monitoring is costly

Question 7

Agency Problem

Answer 7

It happens when one party is expected to act to the other’s interest. However, agent is motivated by self-interest which is not always the same as principle’s interest.
(To reduce this, shareholders should act through incentives or threat)
- Moral hazard
- Imperfect information
- Hidden or Information symmetry.

Question 8

Moral Hazard

Answer 8

Usually occur when agents have more information than principles or incomplete monitor or agents have incentive to act inappropriately.
It can also be the laziness, apathetic of managers, spend money of company on first-class travel which lead to reduction of profitability.
Another is manager is shielded by poor decision making.

Question 9

Imperfect observation and shinking

Answer 9

Hidden information and action lead to information symmetry.

Question 10

Solution

Answer 10

Impost control structure upon agent
Impost internal control
Write better contract
Government schemes like
- Executive compensation scheme (Provide reward and punishment to aim aligning all interest when agents have significant informational advantage and monitor is problematic)
- Governance structures