Agency Costs

Shareholders, bondholders, employees, customers, management, suppliers, etc. All of these are called stakeholders. Much debate as to which group deserves most attention. Although there is widespread agreement that shareholders are the most important group of stakeholders, there are still many conflicts between the various stakeholder groups. Bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer

An agency cost is an economic concept on the cost incurred by an organization that is associated with problems such as divergent management-shareholder objectives and information asymmetry.

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 of the agent. This information asymmetry causes the agency problems of moral hazard and adverse selection.

According to Ross and Westerfield when a firm has debt, conflicts of interest arise between shareholders and bondholders. Because of this, shareholders are tempted to pursue selfish strategies, imposing agency costs on the firm. These strategies are costly, because they lower the market value of the whole firm.

Followings are examples to agency costs that a firm might have to incur:

  • profit-sharing bonuses
  • contingency fees
  • sales commissions
  • merit raises
  • executive stock options
  • and various other contractually specified methods of setting the amount of the agent's financial compensation in proportion to measurable results



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