How can agency cost be reduced

The payment of the agency cost is to the acting agent. Agency costs can occur when the interests of the executive management of a corporation conflict with its shareholders. Shareholders may want management to run the company in a certain manner, which increases shareholder value.

As a result, the shareholders would experience agency costs. The opposing party dynamic is called the principal-agent relationship , which primarily refers to the relationships between shareholders and management personnel. In this scenario, the shareholders are principals, and the management operatives act as agents. However, the principal-agent relationship may also refer to other pairs of connected parties with similar power characteristics.

For example, the relationship between politicians the agents , and the voters the principals can result in agency costs. If the politicians promise to take certain legislative actions while running for election and once elected, don't fulfill those promises, the voters experience agency costs. In an extension of the principal-agent dynamic known as the "multiple principal problems" describes a scenario where a person acts on behalf of a group of other individuals.

Agency costs include any fees associated with managing the needs of conflicting parties, in the process of evaluating and resolving disputes.

This cost is also known as agency risk. Agency costs are necessary expenses within any organization where the principals do not yield complete autonomous power. Due to their failure to operate in a way that benefits the agents working underneath them, it can ultimately negatively impact their profitability. These costs also refer to economic incentives such as performance bonuses , stock options, and other carrots, which would stimulate agents to execute their duties properly.

The agent's purpose is to help a company thrive, thereby aligning the interests of all stakeholders. Also, if a specific action triggers enough shareholders to sell their shares, a mass sell-off could happen, resulting in a decline in the stock price.

As a result, companies have a financial interest in benefitting shareholders and improving the company's financial position, as failing to do so could result in stock prices dropping. Develop and improve products. List of Partners vendors.

The agency cost of debt is the conflict of interest between shareholders and debtholders or creditors of a firm based on the decisions made by management.

The agency costs of debt would specifically be the actions taken by debtholders in restricting what management can do with their capital if they believe that management favors actions that would help shareholders instead of debtholders. The agency cost of debt is often paired with the agency cost of equity, which is the conflict of interest that arises between management the shareholders.

Public companies are complex machines that have a variety of players. All of these players are aligned in that they want the business to succeed, however, certain actions lead to certain players benefiting more, which creates conflicts of interest.

For example, managers may want to engage in risky actions they hope will benefit shareholders, who seek a high rate of return. Debtholders, who are typically interested in a safer investment, may want to place restrictions on the use of their money to reduce risk. The costs resulting from these conflicts are known as the agency cost of debt.

With managers in control of their money, the chances that there are principal-agent problems for debtholders are quite high. Implementing debt covenants allows lenders to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business. Covenants are often represented in terms of key financial ratios that are required to be maintained, such as a maximum debt-to-asset ratio. They can cover working capital levels or even the retention of key employees.

If a covenant is broken, the lender typically has the right to call back the debt obligation from the borrower. There are a number of regulations and laws that define the relationship between the principal debtholder and the agent management , aimed to minimize the effects of the conflict of interest. Agency cost of equity refers to the conflict of interest that arises between management and shareholders. The agency problem emanates from the arrangement where the interest of the agent differs substantially from those of the principal because of the impossibility of perfect contraction for every possible act of an agent whose decisions affect both his own welfare and the welfare of the principal.

There are two polar positions for dealing with agency problems. In this case, agency costs will be low because managers have high incentives to maximize shareholder wealth.

It would be extremely difficult. At the other extreme, stockholders could monitor every managerial action, but it would be extremely costly and inefficient.

The optimal solution lies between the extremes, where executive compensation is tried to perform, but monitoring is also undertaken. Most publicly traded firms now employ performance shares, which are shares of stock given to executives no the basis of performance as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes. If performance is under the target, however, they accept less than percent of the shares.

Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives. First, they offer executives incentives to take actions that will prolong shareholder wealth. Often the advisor is forced to choose between doing right by his client and maximizing his paycheck. If the advisor receives a set salary or earns commission based on total assets under management rather than specific product sales, the agency problem disappears.

The agency problem happens when conflicts of interest keep one party from acting in the best interest of another party. By taking specific steps and staying organized, you can minimize the chance of this happening in your business. The QuickBooks Self-Employed app helps freelancers, contractors, and sole proprietors track and manage your business on the go.

Download the app today. Illustrating the Agency Problem Imagine receiving a windfall of money and hiring a financial advisor to invest it for you.