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Agency Theory

CPA

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JOEL ALUOCH
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14 views

Agency Theory

CPA

Uploaded by

JOEL ALUOCH
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Agency Theory

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The Agency Theory
• -Agency relationship arises where party
(principal) hires another (agent) to perform on his
behalf some services and delegates decision
making authority, to the agent.
• Agency problem arises when there us divergence
of interest between the principal and the agent
• Different agency relationships exist;
– Shareholders Vs Management
– Shareholders Vs Bond Holders
– Shareholders Vs Management Vs Government
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Shareholders Vs Management

• Shareholders are the owners of the firms,


however, they cannot directly manage the firm
because;
They are too many to run a single firm
Lack of technical skills to run the firm
Geographically dispersed
Time constraints

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• Managers might take actions that will not
increase the value of shareholders’ wealth and
they include;
• Motivation problem
• Consumption of high ‘perquisites’
• Different risk profile
• Different in investment evaluation horizons
• Pursuit of power and self esteem goals
• Creative accounting

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Solution to the Agency Problem
• Pegging managerial compensation to performance
• Threat of firing
• Corporate governance
• Threat of hostile takeover
• Executive Share Options Plan (ESOP)
• Incurring agency costs
– Contracting costs
– Monitoring cost
– Residual loss
– Restructuring cost
• Direct intervention by the shareholders
– Sponsoring a motion at AGM
– Making recommendations to management on how
to run a firm

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Shareholders Vs Bond Holders

• Bondholders are providers or lenders of long term debt


capital. They will usually give debt capital to the firm on the
strength of;
– Existing asset structure of the firm
– Expected asset structure
– Existing capital structure/gearing level of the firm
– Expected capital structure/gearing after borrowing the new
debt
• in this agency relationship, shareholders are the agent who
should ensure that the debt capital borrowed is effectively
utilized without reduction in wealth of the bondholders (the
principals, since they provide financing).
• Wealth of bondholders = Market value of bonds * Number
of bonds
issued

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• The agency problem arises when the shareholders take
actions that will reduce the market value of the bond and
by extension the wealth of the bondholders. These actions
include;
– Disposal of assets used as collateral for the debt
– Asset/investment substitution
– Payment of high dividends
– Under investment
– Borrowing more debt capital

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Solutions to the agency problem
i. Restrictive bond covenants
• No disposal of assets without lender’s permission
• No payment of dividends
• Maintenance of a given level of liquidity
• No borrowing of more debt, before fully servicing for the current
debt
ii. Call provisions
iii. Transfer of assets
iv. Refuse to lend
v. Representation in the BOD
vi. Convertibility clause

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Shareholders Vs Government
• Firms operate in an environment using license granted by
the government.
• The government in this agency relationship is the principal
while the firm is the agent (in cases, where it has to collect
tax on behalf of the government especially WHT and PAYE)
• Shareholders may take actions that might prejudice the
interests of the government;
– Tax evasion
– Involvement in illegal business activity
– Lack of adequate interest in the safety of the employees and
products and services of the company
– Lukewarm response to social responsibility

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Solutions to the agency problem
i. Incurring monitoring costs
– Statutory audits
– VAT refund audit
– Back duty investigation costs to recover tax evaded
ii. Representation
iii. Legislations
iv. Offering investment incentive

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Ole Sangale Road, Madaraka Estate. PO Box 59857-00200, Nairobi, Kenya
Tel: (+254) (0)703 034000/200/300 Fax : +254 (0)20 607498
Email: [email protected] Website: www.strathmore.edu
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