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Agency cost

An agency cost is an economic concept concerning the ghanta cost to a "principal" (an organization, person or group of persons), when the principal chooses or hires an "agent" to act on its behalf. Because the two parties have different interests and the agent has more information, the principal cannot directly ensure that its agent is always acting in its (the principals') best interests.[1] Common examples of this cost include that borne by shareholders (the principal), when corporate management (the agent) buys other companies to expand its power, or spends money on wasteful pet projects, instead of maximizing the value of the corporation's worth; or by the voters of a politician's district (the principal) when the politician (the agent) passes legislation helpful to large contributors to their campaign rather than the voters.[2] Though effects of agency cost are present in any agency relationship, the term is most used in business contexts. The information asymmetry that exists between shareholders and the Chief Executive Officer is generally considered to be a classic example of a principal–agent problem. The agent (the manager) is working on behalf of the principal (the shareholders), who does not observe the actions, or many of the actions, or is not aware of the repercussions of many of the actions of the agent. Most importantly, even if there was no asymmetric information, the design of the manager's contract would be crucial in order to maintain the relationship between their actions and the interests of shareholders. Information asymmetry contributes to moral hazard and adverse selection problems. Agency costs mainly arise due to contracting costs and the divergence of control, separation of ownership and control and the different objectives (rather than shareholder maximization) the managers. Professor Michael Jensen of the Harvard Business School and the late Professor William Meckling of the Simon School of Business, University of Rochester wrote an influential paper in 1976 titled "Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure".[3] Professor Jensen also wrote an important paper with Eugene Fama of University of Chicago titled "Agency Problems and Residual Claims".[4] There are various actors in the field and various objectives that can incur costly correctional behaviour. The various actors are mentioned and their objectives are given below. [edit]Management The classic case of corporate agency cost is the professional manager -- specifically the CEO -- with only a small stake in ownership, having interests differing from those of firm's owners. Instead of making the company more efficient and profitable, the CEO may be tempted into: empire-building (i.e. increasing the size of the corporation, rather than the size of its profits [5], "which usually increases the executives' prestige, perks, compensation", etc, but at the expense of the efficiency and thus value of the firm); not firing subordinates whose mediocrity or even incompetence may be outweighed by their value as yes-men or golf partners[6]; retaining large amounts of cash, that while wasteful, gives independence from capital markets [7]; and of course a maximum of compensation with a minimum of "strings" -- in the form of pressure to perform -- attached.[8] Venturing onto fraud, management may even manipulate financial figures to optimize bonuses and stock-price-related options. [edit]Bondholders Bondholders typically value a risk-averse strategy since they do not benefit from higher profits. Stockholders on the other hand have an interest in taking on more risk. If a risky projects succeeds shareholders will get all of the profits themselves, whereas if the projects fail the risk maybe shared with the bondholder (although the bondholder has a higher priority for repayment in case of issuer bankruptcy than a shareholder[9]). Because bondholders know this, they often have costly and large ex-ante contracts in place prohibiting the management from taking on very risky projects that might arise, or they will simply raise the interest rate demanded, increasing the cost of capital for the company. [edit]Board of directors In the literature, the board of directors is typically viewed as aligned with either management or the shareholders. [edit]Labour Labour is sometimes aligned with stockholders and sometimes with management. They too share the same risk-averse strategy, since they cannot diversify their labour whereas the stockholders can diversify their stake in the equity. Risk averse projects reduce the risk of bankruptcy and in turn reduce the chances of job-loss. On the other hand, if the CEO is clearly underperforming then the company is in threat of a hostile takeover which is sometimes associated with job-loss. They are therefore likely to give the CEO considerable leeway in taking risk averse projects, but if the manager is clearly underperforming, they will likely signal that to the stockholders.

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