Principal Agency Problem: Causes and Costs

Topics: Conflict, Political corruption, Fiduciary Pages: 6 (1905 words) Published: May 2, 2014
DISCUSS THE CAUSES AND COSTS ASSOCIATED WITH PRINCIPAL AGENCY PROBLEM (10) Principal agency problem refers to a conflict arising when people appointed (agents) and entrusted to look after the interests of others (principals) use the authority, power or resources for their own benefit instead. It is a pervasive problem and exists in practically every organisation whether a business, church, club or government. Organisations try to solve it by instituting measures such as tough screening processes, incentives for good behaviour and punishments for bad behaviour and watchdog bodies but no organisation can remedy it completely. This is because the costs of remedy usually outweigh the worth of the results. The agency problem arises because the objectives of managers may differ from those of shareholders. In financial management objective of the shareholders is primarily to maximise profits thus shareholder value, whereas managers may be concerned with personal growth and enrichment through excessive salaries and allowances, which automatically diminishes the profit margins for the shareholders hence the principal agency problem. Managers may also invest in wasteful pet projects or buy more companies to increase their power instead of maximising the value of the corporation’s worth. It is one of the most noticed problems in the current Zimbabwean situation when most companies are not being managed by the owners themselves, especially in the various government parastatals. Another common cause of the agency problem is the asymmetry of information, such that shareholders have access to less information about the company than the managers and directors making it hard for shareholders to monitor the actions and decisions of the management. The managers as the agents therefore have room to pursue their own agendas and the shareholders are left with very little to do due to the information constraint. The costs associated with the agency problem consists of three main sources which are, the costs inherently associated with using an agent, for instance, the risk that agents will use organisational resources for their own benefit. The second source of costs is the costs of techniques used to mitigate the problems associated with using an agent, gathering more information on what the agent is doing, for example the cost of producing financial statements. More costs could also arise from employing mechanisms to align the interests of the agent with those of the principal for example by compensating executives with equity payments such as stock options. These are ways of ensuring the agent has the best interests of the organisation but they are costly. b. Discuss the reasons why small, medium sized entities (SMEs) might experience less conflict between the objectives of shareholders and directors than large listed companies. Small and medium sized entities (SMEs) usually experience less conflict between the objectives of shareholders and directors as compared to large listed companies. This emanates from the size of the entities, that is, the smaller the organisation is, the easier it is to communicate and agree on objectives as the organisation grows it becomes more difficult to communicate effectively, monitor and manage. Conflict between the objectives of shareholders and directors in large listed companies is associated with the agency problem. The agency problem arises because of the conflict of interests between managers who are the agents appointed and entrusted to act on behalf of the shareholders who are the principals. In financial management managers are appointed to increase shareholders’ worth by generating as much profit as possible in the respective business entities entrusted to them. This entails that the interest of shareholders is profit maximisation which however in many cases clash with the interests of managers and directors who may end up diminishing the profit margins by enriching and empowering themselves...

References: K Cloke, J Goldsmith; Resolving Conflicts at Work (2005), Revised Edition
O Ramsbotham et al; Contemporary Conflict Resolution (2009), 2nd Edition
Independent Commission against Corruption; Managing Conflicts Of Interest In The Public Sector, Guidelines, (November 2004)
D Frank; “Capital Markets: Pity The Old Retailer Bondholder” (1989).
Shleifer A and RW Vishny (1997); A Survey of Corporate Governance, The Journal Of Finance, Vol. 52, No. 2, pp737-61
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